August 10th, 2022 | By: The Startups Team
Continuing in Phase Three of a four-part Funding Series:
Phase One - Structuring a Fundraise
Phase Two - Investor Selection
Phase Three - The Pitch
Part 1 - Anatomy of a Pitch
Part 2 - Market Size
Part 3 - Revenue Model
Part 4 - Operating Model ( ←YOU ARE HERE 😀)
Part 5 - Customer Definition
Part 6 - Customer Acquisition
Part 7 - Funding
Part 8 - Key Pitch Assets
Part 9 - Traction
Phase Four - Investor Outreach
Let’s dive in!
If the Revenue Model is all about the clever ways you’re going to make money, the Operating Model is all about the clever ways you’re going to manage costs and efficiencies to earn it.
Often the Operating Model gets the least amount of love. That’s because we’re so worked up about solving a problem and creating a path to revenue that the idea of isolating critical cost factors and driving operational efficiencies seems so far away.
While not a necessary step, using an operating model canvas provides a visual representation of operating models that can be useful in both operating model design as well as presenting it to other members of the leadership team or investors.
In other cases, the Operating Model actually is the business model. Think of a young (but still bald) Jeff Bezos creating Amazon.com for the first time. He thought deeply about how the supply chain for products using e-commerce could fundamentally change pricing. Selling books wasn’t a new industry — but changing the methodology for selling books (e-commerce vs. physical stores, centralizing inventory into massive distribution centers) was a revolutionary business process integration for its time. Operating models shouldn't be thought of as secondary to the revenue model, they are pistons of the same engine.
Your Operating Model may not be that revolutionary — it may be downright boring. However, a good operating model focuses on showing that you’ve thought carefully about how your processes will handle critical costs and streamline operations across business units. This also shows you’ve combed through problems in more detail in your operating model. The operating model determines business processes that ultimately lead to things like profitability and investment decisions.
You’ve got a ton of costs that will go into your business model, from buying inventory to leasing questionably suitable office space or other infrastructure costs. When presenting operating models to investors, they don’t care about all of your costs — they care about your Critical Costs. The ones that directly drive success within the operating model. These are the costs that will make or break the business if you can’t control them appropriately.
“Each pizza we sell for $10 will have a total cost of $6. If the price per unit rises beyond $6, no amount of fixed cost changes (staff, rent) will be able to fix that.”
“We’re estimating the marketing cost to acquire a customer is going to be $25. Our average sale is $45. So long as we can keep our customer acquisition costs below $25 we will have enough margin to grow with.”
When you’re talking about costs you want to distinctly separate Critical Costs from every other expense. Critical Costs are those that prevent you from ever growing key business units or becoming profitable in the given business model. They aren’t your biggest line items that just happen to be on your P&L — they are core to the operating model.
Your office rent may be the biggest expense today, but as you grow it will become exponentially smaller compared to other costs. It’s an important cost, but not a critical cost that will determine the future success of the business.
You want to center the conversation among investors on just the Critical Costs. That way you can say:
“Hey, if we can manage these costs, the rest of the expenses will either be insignificant or fall in line with scale. But.. if we don’t manage these costs, it’s game over!”
Often your Critical Costs mature over time, growing or shrinking depending on your chosen operating model.
While it only costs you $10 to acquire your first 1,000 users, it may cost you $20 to get the next 10,000 and so on. Conversely, you may have to pay a vendor $200 to manufacture your first 100 units, but $100 to manufacture a run of 500.
Based on your chosen operating model, you’ll want to isolate these thresholds and their milestones very clearly so that an investor can understand exactly where things will get better, or in some cases, scarier!
“If we only sell 50 pizzas a day, our average unit cost will be $8 on a sale of $10. At that point we’re barely breaking even.
However as we scale up to 200 pizzas a day, our unit costs drop significantly to $4, creating a 100% increase in net income.
Our goal is to get the business to 200 pizzas as quickly as possible so that we can leverage this margin to spend on growth.”
If you’re an investor you’re thinking “Aha! So this business is a gold mine if this team can get to 200 pizzas per day. Let’s dig into that Customer Acquisition Plan to see what it’s going to take to get to 200 pizzas."
Chances are if you’re building a business, you’re going to have some significant “Investment Costs.” Investment costs are strategic uses of capital that will have a big Return on Investment (ROI) later. It’s not the “whole cost of the business,” it’s a specific use of capital that is crazy expensive now but could be a huge win later, and these factors heavily into a strong operating model.
The first step is to isolate those investment costs in your current operating model. The second step is to explain how you expect those investments to pay off in your business model.
“We’re going to invest $250,000 of R&D to create our “Pizza-O-Matic MegaOven”. Once developed, this oven will bake pizzas twice as fast as a regular oven allowing us to double the output of a single pizza store with the same amount of space and employees.”
In just a few short sentences you’ve given an investor not only a good sense of where the balance of your funding is going but also what kind of big ROI that investment could generate. The more specific you can be about the ROI the better, such as the impact it would have on unit costs.
You may or may not have Investment Costs, so don’t get too hung up on trying to force this concept into your plan if it’s not a game changer. You simply don’t want to list huge outlays of capital in your Operating Model and Financial Plan if you don’t have a strong position as to why those specific costs are going to greatly benefit the company.
Once you’ve isolated the Critical Costs, you then want to dig into what Operating Efficiencies you’re going to put into place with your current operating model to give your business a sweet competitive advantage over your soon-to-be vanquished foes. Operating efficiencies bring immense value and directly impact the company's success.
Operating Efficiencies come in all forms depending on the operating models. It could be the way you recruit new talent, how you manage customer support costs, or the increasing value your product provides as more users sign up.
Similar to separating your critical costs from every other cost, you’ll want to separate your critical Operating Efficiencies from just general efficiency. A great way to think about the difference is this — what can your operating model do from an efficiency standpoint that no one else can? This is where operating models can become a key element of the value your organization delivers.
Think of how obvious this would be to “Jazzy Jeff” Bezos when pitching how Amazon's operating model delivers value back in the day.
“By centralizing all of our inventory of books into 10 strategically placed distribution centers, we can offer customers 2-day delivery to any location while minimizing the wasted costs of storing unwanted books on high-priced retail shelves.”
If you were an investor listening to Jeff’s operating model, you would have thought “I can definitely see how getting books quickly and saving inventory costs would be a huge advantage at scale.”
Sometimes you don’t even realize you’re building Operating Efficiencies until you zoom out and think critically about what you’re doing with your company. For example, you may not think your upstart ad agency has any Operating Efficiencies — it’s just a bunch of creative people in a room performing different functions with a very low standardization!
But if you look closely you’ll see that every client you serve gives your company an internal operating knowledge that can be used to acquire and service the next client much faster and more successfully due to creating high standardization over time. This brings value to your clients as well as to your company. This would be an example of a specific kind of operating model called a unification model.
You don’t need to be Jeff Bezos to showcase clever efficiencies in your operating model. But let’s face it — if Jeff offers to help, you should probably take him up on that value.
Knowing your competition is as important as knowing your product and your buyer. Market gaps tell you where to develop your product and internal weaknesses tell you where you're vulnerable to losing customers in your current operating model.
A solid Competitive Analysis is your way of showing that you know exactly where you stand among your fiercest competitors and that you have a way to outmaneuver them inherent to your operating model. The best way to think of the argument you're trying to articulate is:
"Here is where we can gain the most customers (offense) and here’s where we could potentially lose them (defense).”
Your Competitive Analysis should start with your SWOT Analysis — Strengths, Opportunities, Weaknesses, and Threats — to borrow one of grad school MBA's favorite tools. After that you can compare the competitors specifically, but until you have a firm grip on what you do well and where you fall short, the value of who your competitors are lacks a structure.
Inside the Investor’s Mind
“This idea sounds good but I’m worried that current or future competition will simply crush this company. I need to know where they are going to stay ahead of their competition in the minds of their customers. I also need to know how they plan on defending whatever market position they capture.”
Lead with your strengths. Talk about what aspects of your product or processes are the best in class and why your customers will fall in love with how you deliver value. Companies win based on their ability to win over customers.
You don’t eat at Wendy’s because it’s less terrible than McDonald’s. You eat them because you like their food a lot more. You also eat there because the Baconator cheeseburger is sooo good!
Side note: Wendy's and McDonalds (along with all "chain" businesses) operate using replication models - an operating model based on repeating the same infrastructure over and over to deliver value consistently by standardizing as many elements, systems, tools, suppliers, across all operating locations as possible. Consistently trained managers, integrated components, and use of the same technology systems and infrastructure are hallmarks of this approach which achieves great benefits in operational model efficiencies.
Talk about why customers love your Baconator. Talk about what value or capabilities you offer that just blows people's minds. Be very descriptive and dig into how those strengths really stand out in your model. Don’t assume for a moment that because you understand the strengths that anyone else does.
Customers dine at Ruth's Chris Steakhouse primarily because it is considered the most upscale dining experience in their city. This lends itself well to special events that command a higher price point.
Our customers use Tinder over traditional dating sites because they get immediate responses from potential matches and the interface is so simple it’s fun.
Customers shop in our local boutique because they want the experience of interacting with our staff and the enjoyment of trying clothes on firsthand.
The best way to present your Strengths is to start in order of your greatest capabilities.
In each of these sections of the SWOT Analysis, begin with a few introductory sentences like the examples above, and then offer a longer narrative explanation of the model below.
Your Opportunities are all about the expansion of the operating model based on your strengths. You realize your competition is sleeping on the job and you’re ready to pounce on that opportunity to eat up some delicious market share. (Hm, all this Baconator talk…)
Your opportunities typically come in three flavors:
Areas your competition is currently weak
Expansion of your customer’s current needs
Develop key untapped markets
Ideally, you can tap into all three opportunity categories or you have some special flavors of your own. Your goal here isn’t to list every last opportunity, it’s to show that the market has obvious room for expansion that some viable startup like you could build a real business in with the right operating model.
This is one of the few times in life where it’s OK to pick on someone else! If you’ve made it this far into the plan it’s because you’ve found a good reason that your would-be competition is dropping the ball where your operating model delivers value.
When sizing up your competition it’s important to have a balanced assessment while being extra cautious not to resort to painting your competition as a weak, one-dimensional entity with a bad operational model. Not only does this come across as desperate or negative, it says to investors that you haven’t really taken the time to do your due diligence and that you have a limited understanding of the competition in your business area.
Here’s an example of a poorly constructed competitor weakness statement:
“Button-down shirt subscription box service Trendy Threads does not offer the same features we do, so they lack innovation.”
Remember, just because a company lacks a specific key feature now doesn’t mean they won’t offer it later (case in point: Instagram introduced its stories feature five years after Snapchat, and Facebook cloned the same feature shortly after Instagram). Instead, focus on how well you know the weakness exists. Show that you have done your homework and that you have a real inside track on why this weakness has legitimate benefits for your company due to your own operational model.
Now let’s imagine if this were your competitor weakness statement:
“Button-down shirt subscription box service Trendy Threads continues to experience a consistent decline in users due to the company’s recent decision to eliminate its more casual product line to focus strictly on the luxury market.”
The more convincing your research on competitor weakness the more excited investors will get. Don’t skimp on key details here.
It’s your job to not only paint a picture of what your customer needs now but also of what your customer needs next. These needs may not be something you can fulfill now, and that’s fine. What’s important here is that you’re showing that you’re thinking further down the road. Identifying the need today can lead to the creation of other business units later.
“Our customers who purchase our iPhone will need apps to download, music to listen to, additional cables to charge with, and listening accessories like headphones and Bluetooth speakers.”
Your expansion of current needs should start with obvious extensions of need and then include a few bigger picture potential areas that you may not even get to. It’s good to show what’s more probable and then what’s possible. Again, this might require a business unit being developed in the future.
If you’re not expanding into current markets then you’re moving into the great unknown - untapped markets.
Untapped markets are equally exciting and terrifying to investors. On the one hand, it gets everyone pumped to think about a ton of low-hanging fruit that can be gobbled up easily. On the other hand that fruit is often sitting in a grove that may or may not even exist.
Your challenge is to show that these untapped markets do in fact exist (read: show your research) and that you can tackle them quickly and efficiently with your value proposition.
“We believe that the market for a low-cost version of iPhones in underdeveloped countries is even bigger than the U.S. market because over two-thirds of citizens have no access to landlines or cabled Internet. Our iPhone Lite combined with a global reach for cellular service will make this critical line of communication both affordable and accessible to millions.”
Don’t let the idea of untapped markets be a golden ticket to making wild claims. Untapped markets only exist if you can build a cogent case around them AND illustrates how your organization delivers on this case. The quality of your case is the difference between an investor nodding their head and shaking it.
Demonstrating your weaknesses isn’t the same as saying “we’re so painfully vulnerable we’re not even viable!” Every business has weaknesses in its operating models, especially in the startup phase.
Your goal here isn't to sugar coat the nature of your weaknesses — it's to articulate them in exact detail to show that you know precisely where to build a defensible position through the operating model itself. Articulating your weaknesses well allows you to talk about what you're going to do about them.
"Our company, Amazon, is particularly concerned about the fact that customers will want to see higher ticket electronics first hand before making a buying decision. We believe that retailers such as Best Buy will consistently get customers through their doors first before they elect to make a buying decision with us.
Therefore, we have to create guarantees on the lowest price that will entice customers to view at Best Buy but purchase on Amazon because the savings are so significant."
Here we aren't sugar-coating the concern. We are highlighting the fact that Amazon will lose customers to Best Buy but are working toward a strategy to curb that customer loss with a lower price. An investor reading that narrative would feel this is a balanced assessment of a weakness coupled with a viable counter-strategy that delivers value.
Similar to the Strengths section, a great way to present this is with a few declarative scenarios of where you're most concerned so that your readers get the gist. Thereafter, craft a more detailed description of why and how those weaknesses and threats are important to the operating model.
Sooner or later (hopefully later) your competition is going to pose some serious threats to your business. In some cases, it may not even be your competition directly, it could be looming legal issues or governance that you’ll have to contend with.
Similar to weaknesses, Founders get nervous about being bold about threats. They think “That will scare investors away!” when in fact being up front about how you identify and mitigate threats is the best way to make investors confident about potential issues.
Your best bet is to get in front of your threats first. Similar to your strengths, list the most painful threats first, then explain how you plan on using some Judo-style moves to take them down.
“The biggest single threat to our Amazon business is the lack of control we have around delivery costs. If UPS and FedEx decide to increase costs exponentially our ability to deliver products at a total price lower than retailers will evaporate.
To combat this, we will negotiate very long-term deals with major carriers. We will offer them exclusivity on volume in exchange for a predetermined rate plan that we can predict for 5-10 years at a time.”
In this example, we’re pointing out (before our investors can) that an increase in delivery costs for a business that relies on delivery is a big deal. But we’re immediately supporting that concern by providing a credible mechanism to offset the threat.
Investors may still have concerns about what the mechanics of the deals with delivery providers may be, but at least now the conversation is about deal mechanics, not whether delivery as a whole will destroy Amazon.
Think of your presentation of threats in two columns — Threat and Mitigation. List your threat in detail, then list your mitigation strategy. In the best-case scenario, you can show investors that you’ve thought of threats they haven’t even considered and already have a plan of attack waiting. It’s that type of presentation that builds much-needed trust during the formative stages of that relationship.
Your competition can be represented as both "categories of competition” as well as "actual competition."
This allows you to create groups of competitors that may share some of the same operating model attributes such as "online retailers" or an emotional category such as "People who hate to shop in stores." You may in fact have many different categories that you compete with and then a few specific competitors that you're concerned about in each. The category approach works well if you have tons of competitors, say if you were an online retailer.
This is more specific to who you can count on your fingers. In this case, you want to be very detailed about who they are, what about them is particularly challenging, and what you plan to do about it through your operating model. There is often a desire to be selective here - and avoid the business leaders in your niche. Chances are, investors will know about them or find them during their own diligence, which will just make you look uninformed. Avoid that like the plague.
In each case, the goal is to be very clear about why each competitor has strengths and weaknesses that you're concerned about. You're better off listing fewer competitors that are a more direct threat and showing your strategy to compete than creating a giant list of every person that has a Website that's tangentially related to you. If you're starting a premier higher education business management program — you'd focus more on Harvard business school as a competitor than a local community college, or say, a New York Times Bestselling business book.
Remember, while the Operating Model may not be as exciting as the Revenue Model, or our Problem Statement, it focuses on showing that you’ve thought carefully about how your processes will handle critical costs and streamline operations across business units. It shows investors that you’ve combed through problems in more detail and laid out business processes that ultimately lead to things like profitability.
These drive success within the operating model and can make or break the business if they are not properly controlled.
One of the key elements This is a strategy where operating models can become a key element of the value your organization delivers.
Your Competitive Analysis should start with your SWOT Analysis (referenced above) and it's your way of showing you have a plan to position yourself to reap victory among your competitors.
Continue to Part 5 - Customer Definition