The accuracy of your model of the world determines your expectations, decisions, behavior, and—in the long run—your results.
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Raising money is necessary only if it allows you to accomplish something that would otherwise be impossible (like building a factory).
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A successful business, roughly defined, provides (1) something of value that (2) other people want or need at (3) a price they’re willing to pay, in a way that (4) satisfies the customer’s needs and expectations so that (5) the business brings in sufficient profit to make it worthwhile for the owners to continue operation.
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great books on finance and accounting already exist. If you’re interested in exploring these topics in more detail after completing chapter 5, I recommend the following books: Financial Intelligence for Entrepreneurs by Karen Berman and Joe Knight Simple Numbers, Straight Talk, Big Profits! by Greg Crabtree Accounting Made Simple by Mike Piper How to Read a Financial Report by John A. Tracy
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online courses like MBA Math (http://mbamath.com) and Bionic Turtle (http://bionicturtle.com) are available if you want to explore these topics in even greater depth. (Many business schools and corporate-finance training programs recommend or require these courses prior to enrollment.)
- Location 1295
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If you’re interested in learning more about statistical analysis after reading chapter 10, I recommend: Thinking Statistically by Uri Bram How to Lie with Statistics by Darrell Huff Turning Numbers into Knowledge by Jonathan Koomey, PhD For an examination of more advanced methods of analysis, Principles of Statistics by M. G. Bulmer is a useful reference.
- Location 1301
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Some businesses thrive by providing a little value to many, and others focus on providing a lot of value to only a few people.
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Roughly defined, a business is a repeatable process that: Creates and delivers something of value . . . That other people want or need . . . At a price they’re willing to pay . . . In a way that satisfies the customer’s needs and expectations . . . So that the business brings in enough Profit to make it worthwhile for the owners to continue operation.
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A venture that doesn’t sell the value it creates is a nonprofit.
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At the core, every business is a collection of five Interdependent processes, each of which flows into the next: Value Creation—discovering what people need or want, then creating it. Marketing—attracting attention and building demand for what you’ve created. Sales—turning prospective customers into paying customers. Value Delivery—giving your customers what you’ve promised and ensuring that they’re satisfied. Finance—bringing in enough money to keep going and make your effort worthwhile.
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If you can’t describe or diagram your business idea in terms of these core processes, you don’t understand it well enough to make it work.1
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Any skill or knowledge that helps you create value, market, sell, deliver value, or manage finances is Economically Valuable—these are the skills we’ll discuss in this book.
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Every business is fundamentally limited by the size and quality of the market
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In practice, I prefer Clayton Alderfer’s version of Maslow’s hierarchy, which he called “ERG theory”: people seek existence, relatedness, and growth, in that order. When people have what they need to survive, they move on to making friends and finding mates. When they’re satisfied with their relationships, they focus on doing things they enjoy and improving their skills in things that interest them. First existence, then relatedness, then growth.
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According to Harvard Business School professors Paul Lawrence and Nitin Nohria, the authors of Driven: How Human Nature Shapes Our Choices, all human beings have four Core Human Drives that have a profound influence on our decisions and actions: The Drive to Acquire—the desire to obtain or collect physical objects, as well as immaterial qualities like status, power, and influence. Businesses built on the drive to acquire include retailers, investment brokerages, and political consulting companies. Companies that promise to make us wealthy, famous, influential, or powerful connect to this drive. The Drive to Bond—the desire to feel valued and loved by forming relationships with others, either platonic or romantic. Businesses built on the drive to bond include restaurants, conferences, and dating services. Companies that promise to make us attractive, well-liked, or highly regarded connect to this drive. The Drive to Learn—the desire to satisfy our curiosity. Businesses built on the drive to learn include academic programs, book publishers, and training workshops. Companies that promise to make us more knowledgeable or competent connect to this drive. The Drive to Defend—the desire to protect ourselves, our loved ones, and our property. Businesses built on the drive to defend include home alarm system manufacturers, insurers, martial arts training programs, and legal services. Companies that promise to keep us safe, eliminate a problem, or prevent bad things from happening connect to this drive. There’s a fifth core drive that Lawrence and Nohria missed: The Drive to Feel—the desire for new sensory stimuli, intense emotional experiences, pleasure, excitement, entertainment, and anticipation. Businesses built on the drive to feel include movie theaters, arcades, concert promoters, and sports teams. Companies that promise to give us pleasure, thrill us, or give us something to look forward to connect with this drive.
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Whenever a group of people have an unmet need in one or more of these areas, a market will form to satisfy that need. As a result, the more drives your offer connects with, the more attractive it will be to your potential market.
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status considerations are present in every level of the Core Human Drives. When you make an offer to a new prospect, they will estimate how your offer will influence their social status. Building Status Signals into your offer is almost always an effective way to increase its appeal to your target market.
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The Ten Ways to Evaluate a Market provide a back-of-the-napkin method you can use to identify the attractiveness of any potential market. Rate each of the ten factors below on a scale of 0 to 10, where 0 is terrible and 10 fantastic. When in doubt, be conservative in your estimate: Urgency. How badly do people want or need this right now? (Renting an old movie is low urgency; seeing the first showing of a new movie on opening night is high urgency, since it only happens once.) Market Size. How many people are purchasing things like this? (The market for underwater basket-weaving courses is very small; the market for cancer cures is massive.) Pricing Potential. What is the highest price a typical purchaser would be willing to spend for a solution? (Lollipops sell for $0.05; aircraft carriers sell for billions.) Cost of Customer Acquisition. How easy is it to acquire a new customer? On average, how much will it cost to generate a sale, in both money and effort? (Restaurants built on high-traffic interstate highways spend little to bring in new customers. Government contractors can spend millions landing major procurement deals.) Cost of Value Delivery. How much will it cost to create and deliver the value offered, in both money and effort? (Delivering files via the internet is almost free; inventing a product and building a factory costs millions.) Uniqueness of Offer. How unique is your offer versus competing offerings in the market, and how easy is it for potential competitors to copy you? (There are many hair salons but very few companies that offer private space travel.) Speed to Market. How soon can you create something to sell? (You can offer to mow a neighbor’s lawn in minutes; opening a bank can take years.) Up-front Investment. How much will you have to invest before you’re ready to sell? (To be a housekeeper, all you need is a set of inexpensive cleaning products. To mine for gold, you need millions to purchase land and excavating equipment.) Upsell Potential. Are there related secondary offers that you could also present to purchasing customers? (Customers who purchase razors need shaving cream and extra blades as well; buy a Frisbee and you won’t need another unless you lose it.) Evergreen Potential. Once the initial offer has been created, how much additional work will you have to put in in order to continue selling? (Business consulting requires ongoing work to get paid; a book can be produced once and then sold over and over as is.) When you’re done with your assessment, add up the score. If the score is 50 or below, move on to another idea—there are better places to invest your energy and resources. If the score is 75 or above, you have a very promising idea—full speed ahead. Anything between 50 and 75 has the potential to pay the bills but won’t be a home run without a huge investment of energy and resources.
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When any two markets are equally attractive in other respects, you’re better off choosing to enter the one with competition. Here’s why: it means you know from the start there’s a market of paying customers for this idea, eliminating your biggest risk.
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Observing your competition from the customer’s perspective can teach you an enormous amount about the market: what value the competitor provides, how they attract attention, what they charge, how they close sales, how they make customers happy, how they deal with issues, and what needs they aren’t yet serving.
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A few hours spent in evaluation can prevent months (or years) of frustration and misplaced effort.
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wheel—Economic Value usually takes on one of twelve standard forms: Product. Create a single tangible item or entity, then sell and deliver it for more than what it cost to make. Service. Provide help or assistance, then charge a fee for the benefits rendered. Shared Resource. Create a durable asset that can be used by many people, then charge for access. Subscription. Offer a benefit on an ongoing basis and charge a recurring fee. Resale. Acquire an asset from a wholesaler, then sell that asset to a retail buyer at a higher price. Lease. Acquire an asset, then allow another person to use that asset for a predefined amount of time in exchange for a fee. Agency. Market and sell an asset or service you don’t own on behalf of a third party, then collect a percentage of the transaction price as a fee. Audience Aggregation. Get the attention of a group of people with certain characteristics, then sell access to that group, in the form of advertising, to another business looking to reach that audience. Loan. Lend a certain amount of money, then collect payments over a predefined period of time equal to the amount of the original loan plus interest at a predefined rate. Option. Offer the ability to take a predefined action for a fixed period of time in exchange for a fee. Insurance. Take on the risk of some specific bad thing happening to the policyholder in exchange for a predefined series of payments, then pay out claims only if the bad thing happens. Capital. Purchase an ownership stake in a business, then collect a corresponding portion of the profit as a one-time payout or ongoing dividend.
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A Product is a tangible form of value. To run a Product-oriented business, you must: Create some sort of tangible item that people want. Produce that item as inexpensively as possible while maintaining an acceptable level of quality. Sell as many units as possible for as high a price as the market will bear. Keep enough inventory of finished product available to fulfill orders as they come in.
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products tend to Scale better than other forms of value, since they can be Duplicated and/or Multiplied
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In order to create a successful Service, your business must: Have employees capable of a skill or ability other people require but can’t, won’t, or don’t want to use themselves. Ensure that the Service is provided at high quality. Attract and retain paying customers.
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In order to create a successful Shared Resource, you must: Create an asset people want to have access to. Serve as many users as you can without affecting the quality of each user’s experience. Charge enough to maintain and improve the Shared Resource over time.
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In order to create a successful Subscription, you must: Provide significant value to each subscriber on a regular basis. Build a subscriber base and continually attract new subscribers to compensate for attrition. Bill customers on a recurring basis. Retain each subscriber as long as possible.
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In order to provide value as a reseller, you must: Purchase a product as inexpensively as possible, usually in bulk. Keep the product in good condition until sale—damaged goods can’t be sold. Find potential purchasers of the product as soon as possible to keep inventory costs low. Sell the product for as high a markup as possible, preferably a multiple of the purchase price.
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The human species, according to the best theory I can form of it, is composed of two distinct races: the men who borrow and the men who lend. —CHARLES LAMB, ESSAYIST
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In order to provide value via a Lease, you must: Acquire an asset people want to use. Lease the asset to a paying customer on favorable terms. Protect yourself from unexpected or adverse events, including the loss or damage of the leased asset.
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In order to provide value via Agency, you must: Find a seller who has a valuable asset. Establish contact and trust with potential buyers of that asset. Negotiate until an agreement is reached on the terms of sale. Collect the agreed-upon fee or commission from the seller.
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So long as there’s a jingle in your head, television isn’t free. —JASON LOVE, MARKETING EXECUTIVE
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In order to provide value via Audience Aggregation, you must: Identify a group of people with common characteristics or interests. Create and maintain some way of attracting that group’s attention. Find third parties who are interested in buying the attention of that audience. Sell access to that audience without alienating the audience itself.
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In order to provide value via Loans, you must: Have some amount of money to lend. Find people who want to borrow that money. Set an interest rate that compensates you adequately for the Loan. Estimate the probability that the Loan won’t be repaid, and avoid preventable losses.
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In order to provide value via Options, you must: Identify some action people might want to take in the future. Offer potential buyers the right to take that action before a specified deadline. Convince potential buyers that the Option is worth the asking price. Enforce the specified deadline on taking action.
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Options are valuable because they allow the purchaser the ability to take a specific action without requiring them to take that action. For example, if you purchase a movie ticket, you have the ability to occupy a seat in the theater, but you don’t have to if a better opportunity presents itself. When you purchase the ticket, all you’re purchasing is the right to exercise the Option to see the movie at the time specified—nothing more.
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In order to provide value via Insurance, you must: Create a binding legal agreement that transfers the risk of a specific bad thing (a “loss”) happening from the policyholder to you. Estimate the risk of that bad thing happening, using available data. Collect the agreed-upon series of payments (called premiums) over time. Pay out legitimate claims on the policy.
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In order to provide value via Capital, you must: Have a pool of resources available to invest. Find a promising business in which you’d be willing to invest. Estimate how much that business is currently worth, how much it may be worth in the future, and the probability that the business will go under, which would result in the loss of your Capital. Negotiate the amount of ownership you’d receive in exchange for the amount of Capital you’re investing.
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Hassles come in many forms. The project or task in question may: Take too much time to complete. Require too much effort to ensure a good result. Distract from other, more important priorities. Involve too much confusion, uncertainty, or complexity. Require costly or intimidating prior experience. Require specialized resources or equipment that’s difficult to obtain.
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People don’t trade money for things when they value their money more highly than they value the things. —ROY H. WILLIAMS, THE WIZARD OF ADS
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The most valuable offers do one or more of the following: Satisfy one or more of the prospect’s Core Human Drives. Offer an attractive and easy-to-visualize End Result. Command the highest Hassle Premium by reducing end-user involvement as much as possible. Satisfy the prospect’s desire for Social Status by providing Status Signals that help them look good in the eyes of other people.
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the Twelve Standard Forms of Value aren’t mutually exclusive: you can offer any number or combination of these forms to your potential customers to see which ones they like best. This strategy is called Modularity.
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By making offers Modular, the business can create and improve each offer in isolation, then mix and match offers as necessary to better serve their customers. It’s like playing with LEGOs: once you have a set of pieces to work with, you can put them together in all sorts of interesting ways.
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Bundling allows you to repurpose value that you have already created to create even more value.
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Unbundling is the opposite of Bundling: it’s taking one offer and splitting it up into multiple offers. A good example of Unbundling is selling downloads of a single song instead of the entire album. Customers may not be willing to pay $10 for the album, but they might be willing to pay a dollar or two for the songs they like. Unbundling the album into individual units opens the way to sales that wouldn’t otherwise happen.
- Location 1963
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The shortest and best way to make your fortune is to let people see clearly that it is in their interests to promote yours. —JEAN DE LA BRUYÈRE, SEVENTEENTH-CENTURY PHILOSOPHER AND SATIRIST
- Location 1972
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Intermediation is useful in complex situations where the purchaser benefits from guidance and help from experts. You’ll often find Intermediaries in areas where there are a lot of options to choose from—like retailers who decide which items to stock. They’re also common in complex negotiations and purchases, like business brokerages who help entrepreneurs put a price on their current business operations, then help them find potential acquiring companies willing to pay what their business is worth.
- Location 1985
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There is only one boss: the customer. And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else. —SAM WALTON, FOUNDER OF WALMART
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it’s amazing how many prospective businesspeople enter the market without something the market wants. That’s why developing and testing a Minimum Viable Offer is so important: it’s the best way to determine whether or not you’ve created something valuable enough to sell before you invest your life savings.
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Without a certain amount of Trust between parties, a Transaction will not take place. No matter what promises are made or how good the deal sounds, no customer is going to be willing to part with their hard-earned money unless they believe you’re capable of delivering what you promise.
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online reviews, credit and background check services, and financial arrangements like escrow accounts exist to help overcome an initial lack of Trust between parties in a Transaction. These offerings break down an important mutual barrier to completing a sale:
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A compromise is the art of dividing a cake in such a way that everyone believes he has the biggest piece. —LUDWIG ERHARD, POLITICIAN AND FORMER CHANCELLOR OF WEST GERMANY
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Common Ground is a precondition of any type of Transaction. Without any areas of overlapping interest, there’s no reason for a prospect to choose to work with you.
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Sales isn’t about convincing somebody to do something that’s not in their best interest. Ideally, you should want what your prospects want: the satisfaction of their desire or the resolution of their problem.
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There are four ways to support a price on something of value: (1) replacement cost, (2) market comparison, (3) discounted cash flow/net present value, and (4) value comparison. These Four Pricing Methods will help you estimate just how much something is potentially worth to your customers.
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replacement cost is usually a “cost-plus” calculation: figure out how much it costs to create, add your desired markup, and set your price appropriately.
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The market comparison method supports a price by answering the question “How much are other things like this selling for?” In the case of the house, this question becomes “How much have houses like this, in this general area, sold for recently?”
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The discounted cash flow (DCF)/ net present value (NPV) method supports a price by answering the question “How much is it worth if it can bring in money over time?” In the case of your house, the question becomes “How much would this house bring in each month if you rented it for a period of time, and how much is that series of cash flows worth as a lump sum today?”
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DCF/NPV is used only for pricing things that can produce an ongoing cash flow, which makes it a very common way to price businesses when they’re sold or acquired—the more profit the business generates each month, the more valuable the business is to the purchaser.
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The value comparison method supports a price by answering the question “Who is this particularly valuable to?” In the case of the house, this question becomes “What features of this house would make it valuable to certain types of people?” Let’s assume the house is in an attractive, safe neighborhood with a top-tier public school nearby. These characteristics would make the house more valuable to families who have school-age kids, particularly if they want to attend that school.
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Most people who are new to business assume that the best way to increase sales is to reduce prices. That’s not necessarily true. Often, raising your prices is an effective way to attract more customers. Discounts attract customers when the offer is a commodity. If there’s no difference between the gasoline at one gas station and another, the station that reduces its gas prices may bring in more customers.
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this idea is called “price elasticity.” Offers with high price elasticity experience major changes in demand when prices go up or down. Offers with low price elasticity experience little fluctuation in demand when prices change.
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As you test different pricing strategies, you’ll notice thresholds where you stop appealing to certain types of customers and start appealing to customers with very different characteristics. This Price Transition Shock can change the experience of operating your business,
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There are two major considerations when setting your prices with Price Transition Shock in mind: (1) potential profitability and (2) ideal customer characteristics.
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The ideal balance depends on your target market. In some markets, it’s easy to serve customers who are attracted to low prices; in others, discount customers can be challenging and rude. Likewise, prospects that don’t blink at high prices can be pleasant and cordial or demanding and snooty. The experience depends on the industry and the prospects’ expectations. One of the businesses I’ve been involved with over the years succeeded in doubling its average order value by eliminating low-priced offers. As a result, profits increased. As a Second-Order Effect, the company’s typical customer changed for the worse: prospects made unreasonable demands more often and acted in disrespectful ways when those demands weren’t met. The short-term financial result was positive, but the change placed extraordinary stress on the staff. On the other hand, a service business I advise decided to quadruple the price of its standard offer and found that its new positioning appealed to its ideal customers: people who valued the firm’s work and took the project seriously. Nonideal customers were turned off by the hike in prices, so they went away. As a result, the company filled its client roster with excellent customers and increased profits by more than 500 percent. The staff is thrilled with the change: they’re doing more work for better clients and getting paid more for their expertise.
- Location 3098
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One of the businesses I’ve been involved with over the years succeeded in doubling its average order value by eliminating low-priced offers. As a result, profits increased. As a Second-Order Effect, the company’s typical customer changed for the worse: prospects made unreasonable demands more often and acted in disrespectful ways when those demands weren’t met. The short-term financial result was positive, but the change placed extraordinary stress on the staff.
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As you change your prices, the prospects attracted to your offer will also change. So long as you maintain Sufficiency, you can choose to appeal to any type of customer you please.
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