In the Internet era, the business model is key

The Internet has changed all of that. Although every startup still needs great people, a huge market, and a killer technology (or at least a scalable one), without the right business model, the venture is toast.

When it comes to the Internet, a business model needs to address more than just revenues, cost, and profit. Companies that rethink and rebuild their business models for the Web can redesign the entire money chain: who pays, who captures value, and what the split between players looks like. With the Web, they also can take advantage of network effects, scalability, and value matching in ways that offline businesses can't.

SCALE MODELS
Successful business models look for leverage points that will catapult their business forward. One powerful leverage point is scalability, or reaching critical mass quickly using the minimum amount of resources possible, and then maximizing this scale to build barriers to entry. In the case of electronic retailers, this may involve reaching a critical mass of suppliers. Amazon.com (Nasdaq: AMZN), for example, leveraged its early relationships with book distributors to become the "World's Largest Bookstore." (Subsequent entrants to online retail, however, may now take advantage of advances in warehousing and logistics planning to build virtual warehouse systems, managed by companies such as GoWarehouse and Logistics2000, ultimately making the capital-intensive approach of Amazon.com a competitive disadvantage.) For the sports equipment retailer Fogdog Sports, one of Draper Fisher Jurvetson's portfolio companies, quickly aggregating a fragmented supplier group provided a barrier to new entrants. And for the free Internet service providers, reaching a critical mass of subscribers quickly was vital to creating competitive barriers around low costs.

How companies achieve scale also determines the sustainability of the business model
. For example, America Online achieved scale and built subscriber switching barriers by investing significant capital into a proprietary network. The growth of the Internet, however, gave rise to new entrants that could piggyback on its lower-cost infrastructure for a much lower, more sustainable cost structure. The free ISP Netzero, which we invested in before it went public, now provides Internet access for one-third to one-half the cost of AOL.

Speed is another vital dimension of achieving scale. How quickly must a business reach critical mass before another entrant steals the show? In the physical world, many franchises fall victim to this challenge. For example, the Jamba Juice franchise, born and rolled out in California, was quickly duplicated by a competitor on the East Coast. Jamba Juice could not achieve scale in enough markets to keep out potential competitors. On the contrary, it provided the idea for a competitor to imitate, ultimately giving away its first-mover advantage.

While the Internet renders such geographical challenges irrelevant, many Web business models have not learned that lesson. Many ISPs began regionally only to lose out later or get absorbed by national brands. Today, several of the utility plays, like Essential.com, a reseller of local utility services, are taking a regional approach. They will do the heavy lifting in opening up the locally regulated utility markets, only to be vulnerable to national brands that may swoop in. Achieving critical mass also means reaching that scale across all relevant markets fast enough not to have to give away the farm.

Another powerful leverage point in a business model is maximizing network effects, by which each new customer personally gains while increasing the value of the whole network. Remember PlanetAll, which provided a platform for managing personal contacts? As new customers entered their personal contacts, they increased the overall value of the database for everyone. With all of those contacts also using PlanetAll, the customer could automatically update addresses, notify friends of travel plans, manage birthdays, et cetera. This network effect created significant switching barriers for the company and real value for its customers.

Network effects can be particularly powerful in the business-to-business space, as B2B exchange platform plays like Desktop.com, Ariba, and WorkExchange illustrate. As more developers write to the Desktop.com platform or more vendors join the Ariba network, the value of the respective platforms increases for all participants. The same is true for WorkExchange, a network for recruiting sites that we have funded: when HotJobs, for example, joins the network, it gains access to additional candidates and job opportunities, increasing the likelihood of a match and thereby improving revenues and user satisfaction for both companies.

VALUE JETS

One final leverage point for business models of online companies is value matching, in which sellers and buyers, whether businesses or consumers, arrive at a mutually satisfactory price point. A number of ventures have managed to restructure their industry's economics and insinuate themselves into the center of the new economic food chain through value matching. Buy.com , for example, has changed the economics of the consumer-electronics distribution business by selling products at cost. It extracts value differently, through a mix of advertising, manufacturer sponsorship, and upselling of value-added products. No offline retailers can sustain this model over time, because they lack Buy.com's volume of both visitors and products.

Other value-matching companies include Priceline.com, the online airline ticket and hotel reservations broker, and GoTo.com, a search engine. Priceline.com matches between the value of expiring inventory, airline seats, and the marginal value of an additional passenger to the system. GoTo.com matches search results according to a pay-for-performance model. Advertisers on the GoTo.com system bid for placement on the list that the search engine returns in response to a query. But they only pay if the searcher clicks through the results to their site. For an advertiser whose choice is between an unqualified banner impression and a qualified lead, the GoTo.com model provides better value. Again, by restructuring the money chain in each of these industries, value has been sliced and diced differently, giving rise to new models that can win.
The business model is one of the key drivers of success for Internet companies today. But rethinking the money chain is not the panacea for all businesses. Talking about the business model is a little like chess: there are some strategies to consider and a few rules, but the players and the game are different each time. Strategies that worked for one company may be the demise of another. The lesson is to look for the leverage points in your business. It's about instant scale, network effects, and value matching. Great people make a business successful, but a powerful business model changes the game altogether.

Jennifer Fonstad is a director at Draper Fisher Jurvetson, which invests in early-stage technology companies.

Source: Jennifer Fonstad, Red Herring,  February 2000 issue