Definition — what a business model is
A business model is the high-level blueprint a company uses to create and deliver value to customers in a way that can generate profit. It spells out what the firm sells (products, services, or access), who the customers are, how revenue is earned, and the main costs and partnerships needed to operate.
Key terms (defined on first use)
– Value proposition: the reason customers choose a product or service — the benefit it delivers and how it differs from alternatives.
– Revenue stream: a source of income (e.g., product sales, subscriptions, commissions).
– ARPU (average revenue per user): total revenue divided by the number of users/customers over a period.
– Conversion rate: the share of prospects or free users who take a desired action (e.g., become paying customers).
Why models matter
A clear business model helps founders prioritize activities, convince investors and employees, and adapt to market shifts. It forces realistic estimates of revenues, costs, and the partnerships or channels required to reach customers. Firms should revisit their model regularly — market conditions, technology, and customer preferences change.
Common business-model types (short descriptions + example)
– Retailer — buys finished goods and sells to end customers (example: membership-based warehouse retailers).
– Manufacturer — sources raw materials and produces finished products for sale to distributors, retailers, or directly to customers (example: auto makers).
– Fee-for-service — charges for labor or expertise, often by the hour or per engagement (example: law or consulting firms).
– Subscription — customers pay repeatedly (monthly or yearly) for continued access to a product or service (example: music streaming).
– Freemium — basic service is free; a paid tier offers advanced features (example: professional networking sites with premium accounts).
– Bundling — selling multiple products or services together, often at a price discount, to increase per-customer revenue (example: telecom packages).
– Marketplace — a platform that connects buyers and sellers and earns fees or commissions for facilitating transactions (example: online auction and marketplace platforms).
– Affiliate — an entity promotes products for others and earns commissions on resulting sales or leads.
– Razor-and-blade — a low-cost core item (razor) is sold to drive ongoing demand for a complementary consumable (blade) that yields recurring margin.
– Reverse razor-and-blade — the consumable or service is low-cost while the core durable carries the margin (cases vary by industry).
– Franchise — an independent owner operates under a brand and business system in exchange for fees and royalties.
– Pay-as-you-go (usage-based) — customers pay according to how much they use a resource or service.
– Brokerage — earns fees by matching buyers and sellers or arranging transactions (e.g., financial brokers, real-estate agents).
Evaluating whether a business model is likely to succeed
Look for these features:
– Clear value proposition that meets a measurable customer need.
– Unit economics that work: revenue per customer exceeds incremental cost to acquire and serve that customer.
– Scalable customer acquisition channels (the cost to get each additional customer is manageable).
– Sustainable competitive advantages (brand, network effects, proprietary technology, regulatory moat).
– Flexibility to adapt to changing costs, demand, or competitors.
Checklist — what to include when you document a business model
– One-sentence value proposition.
– Target customer segments and how you reach them (channels).
– Primary revenue streams and pricing approach.
– Key cost categories and major fixed vs. variable costs.
– Core activities, resources, and partners needed to operate.
– Metrics to track (e.g., ARPU, conversion rate, churn, gross margin, payback period).
– Financing needs and basic three-year financial projections.
– Biggest risks and contingency actions.
How to build a business model — step-by-step
1. Define your value proposition: describe the customer problem you solve and why your solution matters.
2. Identify target customers: segment by need, willingness to pay, and acquisition cost.
3. Select revenue mechanisms: pick one or more models (subscription, one-time sale, marketplace, etc.).
4. Map costs and resources: list fixed investments and variable costs per unit/customer.
5. Set key metrics and assumptions: price, conversion rates, churn, gross margin.
6
6. Build a basic financial forecast: translate assumptions into a simple monthly or quarterly model for at least 12–36 months. Include revenue drivers (units, price, ARPU), cost items (fixed vs. variable), gross margin, operating expenses, and cash flow timing. Use conservative, base, and optimistic scenarios.
7. Compute unit economics and core ratios:
– ARPU (average revenue per user): average revenue per customer per period.
– Gross margin: (Revenue − Cost of goods sold) / Revenue. Expressed as a percent.
– CAC (customer acquisition cost): total sales & marketing spend divided by new customers acquired in the period.
– Churn rate: percent of customers lost each period.
– LTV (customer lifetime value): expected gross profit from a customer over its lifetime. A common approximation for subscription businesses: LTV = ARPU × Gross margin / Churn rate (when churn and ARPU are measured for the same period). State your period (monthly/annual) clearly.
– Payback period: time to recover CAC from gross contribution per period. Payback period = CAC / (ARPU × Gross margin per period).
8. Run sensitivity tests: change key inputs (price, churn, CAC, conversion rate) one at a time and in combinations to see their impact on profitability and cash flow. Identify “break-even” values (e.g., the churn rate at which LTV/CAC drops below 1).
9. Validate assumptions with cheap experiments: landing pages, pre-sales, small pilots, A/B tests, or paid ads to measure conversion and CAC before scaling. Replace guesses with measured inputs as soon as data is available.
10. Plan scaling and capital needs: model how variable and fixed costs evolve with growth. Estimate the timing and amount of external financing needed to bridge negative cash flow during customer acquisition and product development phases.
11. Prepare a one-page model summary (for investors or internal review):
– Value proposition and target segment.
– Revenue model(s) and pricing.
– Key unit economics (ARPU, gross margin, CAC, churn, LTV, payback).
– 12–36 month revenue and cash projection snapshot.
– Biggest risks and mitigation actions.
12. Iterate regularly: update the model with real results monthly or quarterly, re-run sensitivities, and re-plan resources accordingly.
Worked numeric example (monthly subscription business)
Assumptions:
– Monthly price per customer = $20.
– ARPU = $20 (one plan, no other revenue).
– Cost of goods sold (hosting, third-party services) per customer = $4 → Gross margin = (20 − 4) / 20 = 80% or 0.80.
– Monthly churn = 5% (0.05).
– CAC = $120.
Calculations:
– Monthly contribution per customer = ARPU × Gross margin = 20 × 0.80 = $16.
– LTV ≈ Contribution per month / Churn = 16 / 0.05 = $320.
– LTV / CAC = 320 / 120 ≈ 2.67 (a common rule of thumb target is >3 for strong unit economics, but targets vary by industry).
– Payback period = CAC / Contribution per month = 120 / 16 = 7.5 months.
Sensitivity example:
– If churn rises to 7%: LTV = 16 / 0.07 ≈ $229; LTV/CAC ≈ 1.91; payback still 7.5 months (payback depends on contribution, not churn).
– If CAC doubles to $240 (with original churn 5%): LTV/CAC = 320 / 240 = 1.33; payback = 240 / 16 = 15 months.
Checklist before scaling
– Are core assumptions (price, conversion, churn, CAC) validated by data or small tests?
– Is gross margin sufficient to support customer acquisition?
– Is LTV/CAC acceptable for your capital appetite and industry norms?
– Do you have cash runway to cover the payback period and operating deficits?
– Have you stress-tested for worse-case churn, lower price, and higher CAC?
Common pitfalls
– Using revenue instead of contribution (gross margin) when computing LTV.
– Mixing periods
– Mixing periods (e.g., computing LTV in years but using monthly churn) — always express churn, ARPU and contribution on the same time base before dividing or multiplying.
More common pitfalls
– Ignoring cohort effects — older cohorts may have different retention and value than recent ones. Aggregates can hide improving or worsening performance.
– Not segmenting by channel/product — CAC and LTV often vary widely by acquisition channel, plan, geography or customer size.
– Using one-off or setup fees as recurring revenue — include them only if they are representative of ongoing value or treat them separately.
– Forgetting reactivation and expansion revenue — upgrades (expansion) and win-back activity change true LTV and should be modeled if material.
– Overlooking time lags — marketing spend this month may produce customers several months later; measure CAC on the same cohort horizon you use for new-customer counts.
How to compute LTV (practical steps)
1. Choose a time base (monthly or yearly). For subscription businesses monthly is common.
2. Calculate ARPU (average revenue per user) on that time base.
3. Calculate contribution per customer = ARPU × gross margin (gross margin = 1 − cost of goods sold as a % of revenue).
4. Determine retention metric:
– If you have monthly churn (c), steady-state expected customer lifetime (in months) ≈ 1 / c.
5. Compute simple LTV (no discounting) = contribution per period × (1 / churn).
Worked numeric example (monthly base)
– ARPU = $40 / month
– Gross margin = 60% → contribution = 40 × 0.60 = $24 / month
– Monthly churn = 5% (0.05)
– LTV = 24 / 0.05 = $480
Discounted LTV (accounts for time value of money)
– Convert discount rate to the same period. Annual discount r = 10% → monthly ≈ (1+0.10)^(1/12) − 1 ≈ 0.798% (0.00798)
– Discounted LTV ≈ contribution / (churn + monthly discount) = 24 / (0.05 + 0.00798) ≈ 24 / 0.05798 ≈ $414
–
Interpretation and next steps
– Compare LTV to customer acquisition cost (CAC). A useful rule of thumb in SaaS and subscription businesses is LTV:CAC ≈ 3:1 (LTV three times CAC) to indicate efficient unit economics. Lower than 1:1 means you lose money acquiring customers; much higher than 3:1 may indicate under-spending on growth.
– Compute payback period = CAC / contribution per period. This tells how many months (or periods) it takes to recover CAC from operating cash flow (contribution). Shorter payback improves cash flow and reduces financing needs.
Worked numeric example (continuing the previous numbers)
– Contribution per month = $24 (from ARPU $40 × gross margin 60%).
– Discounted LTV ≈ $414 (calculated).
– Suppose CAC = $150.
– LTV:CAC = 414 / 150 ≈ 2.76 → slightly below the 3:1 guideline.
– Payback period = CAC / contribution = 150 / 24 ≈ 6.25 months.
– Interpretation: economics look reasonable but not comfortably above the 3:1 benchmark; payback under a year is healthy.
Exact formulas (monthly period basis)
– Simple (no discounting) LTV = contribution per period / churn
– contribution per period = ARPU × gross margin (or revenue per period minus variable costs per period).
– churn = probability a customer leaves in a period.
– Discounted LTV (constant churn c, discount per period d):
– discounted LTV = contribution × sum_{t=1}^∞ [(1 − c)^(t−1) / (1 + d)^t]
– closed form = contribution / (c + d)
– derivation note: geometric series with ratio (1−c)/(1+d) converges when (1−c)/(1+d) 3 is healthy for many SaaS businesses; context matters.)
4. Payback period (simple)
– Payback months = CAC / contribution = 500 / 80 = 6.25 months.
– If you prefer discounted payback, discount the contribution stream until cumulative discounted contributions equal CAC.
Sensitivity checks (quick)
– If churn doubles to 10%: denominator = 0.10 + 0.007974 = 0.107974 → LTV ≈ 80 / 0.107974 ≈ $741.
– If gross margin falls to 60% (contribution $60): with original churn 5% → LTV ≈ 60 / 0.057974 ≈ $1,035.
Run a small table or tornado chart varying churn, margin and CAC to see which inputs most affect LTV:CAC.
Practical checklist before using LTV:CAC to make decisions
– Convert all rates to the same period (monthly/yearly). Use exact conversion for discount rates: (1+annual)^(1/n) − 1.
– Use cohort-level data where possible rather than aggregate averages.
– Separate acquisition spend by source/channel to compute channel-level CAC and compare ROI.
– Decide whether to use gross margin or contribution after variable costs; be consistent.
– Include the expected timing of revenue (upfront vs. recurring) in payback calculations.
– Recompute LTV and CAC at least quarterly; use monthly if unit economics change quickly.
Common pitfalls
– Using lifetime in months/years directly without discounting when evaluating long horizons.
– Treating LTV:CAC rule-of
-thumb as universal without tailoring it to business model, growth stage, margin structure or payback tolerance. A “3:1” target for a low-margin marketplace is not the same as for a high‑margin SaaS business.
– Ignoring fixed and semi‑fixed costs. CAC often captures marketing spend only; failing to allocate relevant sales/overhead can understate true acquisition cost.
– Double counting or omitting refunds, chargebacks and returns that reduce lifetime revenue.
– Using mean values without checking distribution skew. A few high‑value customers can inflate average LTV; median and cohort percentiles matter.
– Small-sample and survivor bias: early cohorts or small channels produce noisy LTVs. Don’t extrapolate long tails from brief data.
– Forgetting seasonality and cohort timing. Customers acquired in season A may have systematically different retention than those in season B.
Worked numeric example (recurring-revenue model)
Assumptions (monthly basis)
– Average Revenue Per User (ARPU) = $50 per month
– Contribution margin (revenue after variable costs) = 70% → contribution per month = 50 × 0.7 = $35
– Monthly churn rate c = 5% = 0.05 (constant probability a customer leaves each month)
– Annual discount rate = 12% → monthly d = (1+0.12)^(1/12) − 1 ≈ 0.009488
Formula for LTV with constant churn and discounting
– Let r = retention = 1 − c.
– LTV = sum_{t=1 to ∞} (contribution × r^{t-1}) / (1 + d)^t
– Closed form simplifies to: L