We need filters in life; lenses with which we make sense of the world. The same is true in business. A lot of my work involves helping students, entrepreneurs, and executives filter ideas and opportunities. For students, the possibilities for what they do after they graduate can lead to stasis due to paradox of choice. For entrepreneurs - during this true golden age of startups - deciding what to spend scarce time and resources on can be one of the most crucial decisions they make. For executives who are managing business development and growth choices, they are frequently forced to decide between competing initiatives.
Too often, all of the above lean on gut to make choices at the top-level stage. That is, amidst the flurry of options, filtering through the noise at the high-level stage — prior to true due diligence — is done without any type of filter.
To address this, I’ve developed a matrix to help quickly categorize ideas at the top level stage. This filter can be used to quickly discard those which will nearly certainly fail, and to better quantify those left.
While not a comprehensive analysis, this matrix seems to provide quicker insights than SWOT, Five Forces, et al....not that there’s anything wrong with those.
Quadrant 1: High Touch Quadrant 2: Low Touch Quadrant 3: High Margin Quadrant 4: Low Margin
All businesses must choose one from the left column and one from the right. Certainly, there are gradients, and certainly some businesses start with one quadrant (High Touch) and move to another (Low Touch), but — keeping in mind that this matrix is only meant to filter the top level ideas, the above matrix is very durable and can provide insights.
1+3: The Lifestyle Business...Doesn’t scale
Think of a tailor; perhaps the tailor of Panama....or anyone on Seville Row who made James Bond’s clothes. These artisans create bespoke, one-of-a-kind suits that due to their custom nature can only be created in limited quantities. But...they charge a high premium for this customization. Perhaps the tailor can “only” make 50 suits a year (~4 per month), but she charges $10,000 per suit. That results in gross revenue of $500,000. Certainly, COGS will be high, but even if the COGS for each suit is $2,000 per suit, that’s still a $400,000 net profit. These types of businesses tend to enjoy repeat customers and high NPS, and so their marketing costs are low. There may be some nominal overhead, but what people are dominantly paying for is this person’s time and skill, and when people are paying you for time and skill, there is a perceived value that de-tethers from cost+/commoditized models.
These can be GREAT businesses, but they inherently do not scale.
There is an inverse relationship to scale and pricing. That is, the more you try to churn out, the less dear the customer perceives the item, and the margins compress.
Imagine our tailor being told that she must go from making 50 suits per year to 50,000. Impossible to do this without losing the custom nature.
Other examples of these types of businesses include: artist managers, fine artists, high-wealth money managers, ultra high-end restaurants, etc.
This is not to say there aren’t adjacent products that can drive revenue — fine artists create prints — but, the core business doesn’t scale.
2+4: The Subscription Model...Churn
This is a dense category; many businesses fall into it. I call it “The Subscription Model,” because I have experienced this first-hand having run these types of companies. Here, the business attempts to create a scaleable product that requires little-to-no customization/customer support.
The problem with these models is that they quickly become commoditized. That is, any company that comes up with a subscription or ad-based model that works — Netflix, NYT, Twitter, etc. — will quickly be met with competition that forces the customer to choose between their option and a similar offering....often one with a slightly lower price or slightly differentiated product.
What this means is that while a firm may enjoy a period of fast growth when they have a novel offering; they will quickly be confronted with competitors taking their customers away.
Netflix certainly had a period where they were the main streaming offering...but now look at the space: commoditized, people switching based on marginal price and content distinctions, etc.
Do you really think Peloton will be the only exercise product of its kind? Check this space in a year or so.
The music business is a great example of this model. It’s very hard to differentiate the various DSPs, and — unfortunately for the artists — it leads to a loss-leader, race-to-the-bottom pricing model where these services are bundled with higher margin offerings; music as a part of Amazon Prime, etc.
1+4: The Death Spiral
I see this one far more than I would like. It’s sad. It often occurs in the small “business” space, where someone has a passion project, and has literally no idea how much time and money it takes to operate a business and vastly over-estimates what people will pay for their service.
At core, these types of businesses are really hobbies; the home cook who thinks he can make it as a restauranteur; the artisan who opens her own gallery.
You see this at the entrepreneurial and corporate level as well. In these cases, the operators tend to believe that while the costs are high at inception (i.e high touch), and the margins low (or non-existent), that these will invert given enough time.
I suppose, given enough time and money, anything’s possible, but few have the resources to stay alive trying to find this sweet spot.
2+3: The Grail
This is what everyone wants; it’s often what everyone thinks their business will be. It rarely is. These types of businesses are what Peter Thiel describes as “Zero to One” businesses. Those that — because they are so sui generis — scale and have margin.
Examples: Microsoft in its first stage; Google; Facebook; Amazon Web Services, Apple, LVMH.
All of the above essentially had or have something akin to monopolies. That is through technology, patent, contract, etc., they are able to avoid margin compression that typically occurs...see “2+4: Churn” above.
These types of businesses tend to exhaust their “Cash Cow” and become commoditized....unless they truly maintain a Purpose Not Product mindset and constantly innovate; Nintendo, for example.
As stated above, there are gradients: some companies sit between one and two and three and four; some move from one quadrant to another (for better and worse), but the key is to use the above matrix to quickly discard 1+4 while aiming for 2+3. It’s a start.