A Beginner's Guide to Business Models

As you start to think about building a new business, you inevitably work on what the product will be, whom you’ll hire, and what the target market looks like. You need to spend as much time or more determining what your business model will be.

Overview: What is a business model?

The shortest definition of a business model is something like “how the business makes money.” I don’t think that goes far enough. Really, a business model is how you make money combined with the capital implications.

If you’re looking to start a business, you shouldn’t look at the revenue model alone but the revenue model combined with the cost of capital and amount of capital required. The business model is more about how and what return on investment the business can achieve.

8 types of business models

Let’s take a look at eight common business models (with some subsets sprinkled in).

1. Subscription

A subscription business model is any model that generates recurring revenue. The classic example is newspapers. Newspaper companies used to be able to depend on secure revenue streams each month to pay employees and produce their products.

In the online era, the following subscription models have become more common.

• Freemium: The freemium business model provides much of the product for free, usually with an upsell to the premium product. Think about a free email newsletter that advertises an online course.
• Razor Blade: The razor blade model isn’t a perfect subscription because the opt-out is too easy. Razorblade companies offer the razor handle and the first few blades super cheap and then rake in the cash when you go back every month to buy expensive new blades.
• Reverse Razor Blade: Reverse razor blade is where you provide the expensive product first, such as a video game. Then you charge for incremental improvements to the product that the customer must have. Reverse razor blade is often combined with freemium for games. The game is free to download, but almost any upgrade or cool skin comes with a cost.
• SaaS: Software as a Service is a subscription model where there is no or little initial cost for the software. Instead, users pay a recurring fee to license the software and access customer service.

When we do business model analysis, we need to consider the two types of costs: fixed (e.g., capital investment) and variable. Fixed costs are the bare minimum necessary to set up the business and keep it running (rent, product development, equipment, etc.). Variable costs are the costs to deliver each incremental product (customer service, inventory, etc.).

Freemium and SaaS models are similar where they shell out a ton of moolah on fixed costs to build a product and acquire customers. After that, the variable cost of each new customer is basically nil. This is because most freemium and SaaS businesses are online-based.

You’ve reached the high point in a SaaS or freemium life cycle when it becomes a money machine. At that point, customer acquisition costs become more variable, and you can just pull the lever up on advertising and see a good revenue return from each marginal dollar spent.

Many razor blade businesses do need to worry about variable costs because they have to manufacture the blades and keep costs down to make sure no one opts out.

2. Lowest price

The lowest price model focuses on being the cheapest. The business must constantly be worried about pricing structure. Put rows of shelves or airline seats closer together. Find the cheapest raw materials. Forsake customer service.

The keys to a lowest price model are constant vigilance and volume. Keep fixed and variable costs down as low as possible and churn through as many sales as you can. The margin will be low, so you’ll have to make it up in volume.

3. Retail

Retail businesses either purchase or manufacture a product and sell it to the public. Many retailers struggle to meet fixed costs until they reach big box store status and start to benefit from economies of scale.

Online retailers are better off when it comes to fixed costs, especially if they have a product that can be drop-shipped from the manufacturer. Niche retailers have an advantage in that they can charge a premium price. It’s better to be the only Vietnamese/Mexican fusion restaurant in a given area than to be one of 76 different pizza restaurants.

4. Advertising

Advertising is the classic way to get a product to customers for “free.” Here are a few common advertising models.

• Banner ads: Most websites you visit will have banner ads somewhere. Many websites have started to try to diversify away from banners ads because it’s so easy to use an ad blocker.
• Sponsored articles: Similar to a freemium model, many blogs will provide quality free content and then also post articles written by sponsors. This evades the ad blocker and usually has a higher conversion rate for the customer buying the ad.
• Affiliate links: If you Google long enough, you’ll find something like 14,000 different courses for starting an affiliate marketing business. The basic formula is to use lead magnets (free premium content) to build subscribers to an email newsletter (more free premium content), and then recommend affiliate products to email subscribers. Websites can also use the affiliate model. The one you’re on right now does. Generate high-quality content to build an audience, and then review quality products and recommend them to readers. Affiliate marketing is one of the simplest ways to work for yourself.
• Commercials: Most TV channels and video websites use commercials. Cut into the premium programming with 15 seconds to three minutes of advertiser video. You also see this model in the podcast world.

Most businesses that are reliant on ads are constantly trying to find new ways to make money. Doing things like selling company swag, adding premium courses, or even holding conferences diversifies the revenue stream away from fickle advertising dollars.

5. Franchise

Converting to a franchise model should be the goal of most restaurant businesses and many other retail businesses. The classic franchise model is to build a highly successful retail brand and then license the brand to third parties.

Almost every nationwide fast-food restaurant operates under this model. They will have some company-owned stores, but for the most part, the restaurants are owned by franchisees who pay a franchise fee back to the franchisor.

This model is ideal because it takes little to no fixed costs to keep going. Good franchisors will work on creating new products and advertisements, but they don’t need to go through the headache of buying real estate, hiring and paying employees, or serving customers.

6. Middleman

Middlemen are one of the most important features of an evolved economy. Doing accounting in Utah, it would be close to impossible for me to contact and buy corn from a farmer in Illinois. The middleman is the one who creates the relationship with the farmer to buy the corn and then sells it to a retail store close to me.

The capital outlay for a middleman business is usually whatever it costs to purchase the inventory. The middleman is effectively a speculator, buying the inventory in the hope that they can resell it with a markup.

It’s even better if you can get a middleman business going where you don’t have to front the cost of the inventory. Think about an online marketplace. The company gets a fee for listing the product and joining the buyer and seller, but it never has to take possession of the product. All costs are fixed, and the return on investment is sky-high.

7. Service

Service businesses are hard. They inevitably have high fixed and variable costs. For example, an HVAC contractor has to buy or rent an office/warehouse and buy vans and other equipment. Then, for each new transaction, the contractor needs an office person to take calls, gas for the van, and wages for the tech who goes out and does the job.

As you can probably guess, most service businesses live and die based on service. An HVAC contractor is probably paying about the same amount for materials and employees as every other HVAC contractor. The competitive advantage comes from people wanting to do business with you.

8. Leasing

The leasing model has the biggest variance between fixed and variable costs. Fixed costs can be enormous, while variable costs are close to nonexistent.

If you own a self-storage site, you start with massive fixed costs to purchase or build the property. Every year, you pay for taxes and utilities on the site. From there, variable costs would be a few employees to rekey units and assist renters and almost nothing else.

Leasing is the perfect passive business.

Business model examples to help you create your own

Here are a few examples of popular businesses with their models. I don’t have any special knowledge about any of these companies, so I’ll be guessing at the model based on what I’ve read and experienced.

1. The Motley Fool

Let’s start with our favorite financial newsletter company. The Motley Fool’s core business model is a freemium subscription model. It provides tons of free, high-quality content with articles and podcasts about the stock market and points readers to subscribe to various premium newsletters and services.

There are a few banner ads on the site here and there, but you won’t see many. I would guess this is a result of simple cost/benefit analysis. If someone clicks on a banner ad on the website, the company earns what could be as little as a few cents. If they stay on the website, they may eventually purchase a service that costs thousands of dollars per year.

The company also has diversified into other revenue sources, such as books and conferences. This is a way to upsell to existing subscribers who love the company and potentially bring in new subscribers who wouldn’t have joined through the website.

2. McDonald’s

McDonald‘s has had an interesting business model evolution. It started out with a run-of-the-mill retail model with a restaurant. Later on, as it grew in popularity, it started to sell franchises but with a hybrid franchise/leasing model.

Successful franchises are awash with cash. Once they hit their fixed costs, almost every dollar flows directly to the bottom line. The problem then becomes what you can do with the money. There are only so many different types of burgers you can come up with. Once you start selling a double cheeseburger, it doesn’t take much R&D to come up with the triple cheeseburger.

McDonald’s decided to start purchasing the real estate its locations are on and then lease the sites back to the franchisees. It’s the perfect model. McDonald’s builds a diversified portfolio of in-demand and high-return real estate with its hoard of cash. If the franchise fails, McDonald’s doesn’t have to worry about vacancy. It just sends a new operator to the site until it can sell it to someone new.

3. Netflix

Netflix has evolved as well. You could say it’s always had a subscription model. In the beginning, it had recurring revenue with huge fixed costs to buy DVDs, but now it has recurring revenue with huge fixed costs to license and create content.

The difference is in the variable costs. In its original iteration, Netflix constantly had to buy new DVDs to replace damaged ones and to have all the newest movies.

Modern Netflix has negligible marginal costs for new subscribers. It has to pay billions to re-license and create new content every few years, but it’s working toward a future where the majority of its content will be Netflix-created. Selling subscriptions for content that was created and paid for years ago is the ideal model.

Choose your model

As you increase your business acumen and develop your business, you’ll naturally lean toward business models that are low on capital costs and high on profits. Learning about the models ahead of time will go a long way toward increasing your profit in the future.