You May Be Copying a Bad Business Model

About five years ago, I was involved in a new consumer services business that was the talk of the town. Friends and colleagues, seeing the flood of customers and press, often commented that “you guys must be making money hand over fist.” Truth was, we weren’t. Providing our services was expensive, and we were struggling to deliver a sustainable profit. What was good for the customer wasn’t always good for the business or our investors. Anyone who copied our model at the time would have made the same mistakes, and many did.

In a similar vein, two years ago I began working with a client who was self-funding his business and was concerned about a well-financed competitor. This competitor was spending a lot of money on features and development without really showing traction with the core demographic. My advice to my client was to ignore this big spender, keep his head down and focus on attracting and keeping profitable customers. Sure enough, about four months and $5M in venture capital later, the competitor went under. Not only is my client still in business, he is a market leader and has used significantly less capital.

No start-up can afford to follow the practices or business model of a competitor unless they are certain that model is working. And when I say “working,” I mean profitable. Many companies are overfunded by investors who can go for broke because they have a portfolio strategy; others are backed by friends and family who have little relevant investment experience. Such circumstances often explain how businesses keep going long past the point where a traditional lender such as a bank would have pulled the plug. I’ve also found that when managers aren’t spending their own money, they tend to favor the customer even at the expense of profit.

Bottom line? It’s a critical and often fatal mistake to try to judge whether a company is making money by looking at the “front end” of the business, such as the growth of users or perceived popularity. What drives profitability for almost all business is actually how well they manage the “back of the house,” the unsexy operations. This is where good management, strong systems and a focus on cash flow rule. This is also why gross margins are the biggest false indicator in business. As an example, imagine you run a class and make $100. If the teacher costs $25, your accountant will tell you that your gross margin is $75 or 75%. But what about the cost of the classroom, the cost of marketing, and the expense of training teachers? These kind of expenses can quickly turn a 75% gross margin business into a money loser.

Investors and consumers continually fall into the trap of assuming that a popular business is a profitable one. The reality is the majority of very sustainably profitable business are decidedly unsexy. There are exceptions though such as ING Direct, which offers a very popular and simple high-interest online savings account. ING is able to pay this attractive rate because the bank has no branches and uses a fully automated online system. The company then uses these savings deposits to make low-cost mortgage and home equity loans to very high quality borrowers with a similar streamlined and efficient online process. Customers love ING Direct and the parent company loves the business unit because it has found a way to deliver a service customers value in a way that also is very profitable. This combination is a sustainable competitive advantage, something every business would like to have.

The key message here is, if you are trying to judge a competitor or find a model for your own business, make sure that you know for a fact that it is profitable—especially if you are funding your business with your own money. What you see on the surface may be very misleading.

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