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Business Models and Competitive Advantage

High growth depends on how you set yourself up to deliver value into the market. Colin Mason at the Hunter Centre for Entrepreneurship, University of Strathclyde and Ross Brown at Scottish Enterprise report on how fast-growth enterprises design their business models.

The commercial landscape is littered with examples of firms with innovative products or services which failed because they could not achieve profitability – typically either they could not attract sufficient customers or were based on unsound economics. A good product or service is therefore no guarantee of success in the marketplace. Nor is the best technology. A company also needs to have an effective business model. In essence this describes the way in which companies are ‘designed’. New business models can have just as disruptive an effect on the competitive landscape as new technologies. Consider budget airlines. By re-engineering the costs and revenues of running an airline they have undermined the competitive position of the so-called legacy airlines. Free newspapers, such as the Metro, have had a similar effect on the traditional paid-for newspaper industry. Direct Line’s approach to selling insurance over the telephone transformed the personal insurance market, which until then had been sold through brokers. The Internet has facilitated new kinds of business models and the re-invention of older ones (e.g. auctions). Indeed, as products have become increasingly commodified and undifferentiated so business models are now a critical source of competitive advantage precisely by providing a source of differentiation.

Business models: a definition

At its most basic, a business model is the story of how a company operates. In slightly more detail, it describes how a company competes, uses it resources, structures its relationships, interfaces with customers, and creates and captures value to sustain itself. The key elements in a business model include the following:

  • The customer value proposition – how will the company create value, and for whom?
  • The profit model – how will the company make money?
  • The key resources needed to deliver the customer value proposition.
  • The company’s core competences – internal capabilities or skill sets that enable the company to manage the business in a way that delivers value.

There are various generic forms of business model. But ultimately every company’s business model is unique because it is dependent on the collection of resources it controls and the capabilities that is possesses. Copying another company’s business model is unlikely to be successful. However, over time competitors will be able to emulate the distinctive features of an innovative business model. Changes in the external environment may also reduce a business model’s effectiveness. Companies therefore need to continually review and refine their own business model.

Case studies of high-growth companies [Note 1]

It is clear from our interviews with more than 20 high-growth Scottish companies [Note 2] that innovative business models are a necessary – albeit not sufficient – condition for growth. They are a critical source of their competitiveness, providing a value proposition that is not based on price. Although every company’s business model is ultimately unique, many features are repeated. These include recurring revenue streams, multiple revenue streams, partnering and close relationships with customers.

One of the most common generic types of business model is the tied-product model involving the sale of the basic product at low cost, or even a loss, as ‘bait, then charging a premium for refills, replacements or usage. This model is commonly associated with razor blades, photocopying and printer ink. Optos, which is listed on the Stock Exchange’s Main Market, operates on the basis of a novel variation of this model. The company designs, develops, manufactures and markets retinal imaging devices to detect and diagnose eye problems. The resulting optomap exam can lead to early detection of common diseases of the eye. Its technology is leading edge.

The company operates on a basis of a pay-per-patient (‘PPP’) model, which it describes as ‘a key component of its strategy’. Rather than selling these machines (which cost £150,000), clinicians typically enter into a fixed-term contract (usually a 36-month term) during which time they pay a fixed minimum monthly payment (MMP) that allows them a minimum monthly number of optomap exams plus a fee for each exam conducted that exceeds the contractual minimum. They receive service, maintenance, patient support, and software and hardware upgrades. With this business model, ownership of the device does not pass on to the customer. Clinicians therefore have no capital outlay.

These contracts provide Optos with a high degree of predictable recurring revenue from the MMPs over the contract term. Each device installed in the field records the actual number of daily exams performed and reports this back in real-time to the company enabling accurate billing for the additional optomaps above minimum levels. This business model provides security and visibility of future revenues. The company is also able to raise debt finance based around the security of the guaranteed revenue streams offered by these fixed-term contracts with third-party finance houses, with the finance house taking ownership of the underlying device for the period of the loan as further security. Where appropriate, the company will also sell its devices outright. In this model, recurring revenue is generated from service, repair and maintenance and software upgrades through separate financial agreements with these customers. Underlining the dynamic nature of business models, the company has recognized that some potential customers are reluctant to enter into long-term commitments, so now also offers a prepayment arrangement for a set number of examinations with ability to top up at a higher price than the standard contract.

Future revenue from recurring income is also at the heart of Craneware’s business. Craneware, which is listed on the Alternative Investment Market (AIM), supplies a family of software products offering strategic, pricing, revenue cycle and supply management solutions for US hospitals that enhances their revenue capture process. These are sold on a subscription model per licensed user with each contract lasting seven years – the average age of their current contracts is 5.4 years, which indicates the scale of their future revenue flows. From an accounting perspective this revenue is spread over the duration of the contract rather than to the year in which it was obtained. The company’s financials are therefore presented in terms of both annual revenue and future revenue under contract. Their consultancy arm helps to increase the market penetration of their software.

ProStrakan, which is listed on the Main market of the Stock Exchange, has developed an innovative business model within the pharmaceutical industry. The standard business model in this sector is based around drug discovery. Traditional ‘big pharma’ companies invest heavily in basic research to generate new blockbuster drugs. This model costs $200 million from test tube to market ($800 million if the cost of failures are included), has a 10-year timescale, and the chance of success with any new drug development is low. The ‘biotech model’ is based on developing new drugs from specific discovery, usually in universities. It relies on raising venture capital every 18 months or so and ultimately selling out to a big pharma company if it is successful in developing a new drug.

ProStrakan’s business model is very different. It takes existing drugs that are already on the market and reformulates them to be delivered in new ways that better suit the needs of patients. The patents for these drugs may be lapsed, or they are in-licensed from the companies that developed them.  So, for example, it has reformulated a cancer drug developed by Roche as a transdermal patch that delivers steadily into the bloodstream for up to seven days, thereby avoiding the often distressing side effects of chemotherapy. The company has a patent on this new delivery method. Another of its products is a fast-dissolving tablet for the management of cancer pain. The melt technology enables pain relief to be delivered promptly and efficiently. One of the company’s skill sets is getting regulatory approval for these new products. The advantage of this business model is that it is much less capital intensive than the drug discovery model, hence much less risky. It is also much easier to grow from a small base. The trade-off, of course, is that the upside is lower.

A key element in this approach is partnering with big pharma companies around the globe. This takes two forms. First, it partners with other drug companies to acquire products that it can reformulate. This is primarily through in-licensing. Second, its commercial operations are focused on Europe and the USA, so it partners with companies in other parts of the world both to gain regulatory approval and to sell their products. It also out-licenses its reformulated products in Europe and the USA in situations where a specialized sales force is needed. It has also acquired companies in Europe for their infrastructure.

The importance of partnering to access complementary resources is highlighted by two companies in the recycling industry. Stirling Fibre focuses on their core business of processing paper and paper-based waste, where they have the knowledge and infrastructure, and partner with other businesses involved in other stages of the business, such as collection. It processes about 80 per cent of all local authority waste in Scotland. Its diversification into other forms of recycling (plastics, waste into energy) is through joint ventures. Redeem engages in the recovery, refurbishment and recycling of consumer electronic devices on a global basis. It started on the basis of recycling print cartridges and subsequently moved into mobile phones and is now moving into digital camera, MP3 player, laptop and satnav markets.  In the case of printers, their model is to partner with charities, schools, retailers and other organizations as a means of engaging with the public and businesses to give them cartridges. Redeem will either pay the source of the cartridge in cash or loyalty points or will make a donation to charity. Redeem then sells the cartridges worldwide to companies that specialize in mass refilling who then sell them on to retailers to market under their own label. In the case of mobile phones Redeem has agreements with retailers to recover phones. They then data wipe and test them before selling them on to customers – these include African phone networks, insurance companies and traders.

Another type of business model is illustrated by two engineering companies that both present themselves as total solutions providers. This is Star Refrigeration’s business model. It tries to avoid competing on the basis of tendering, which drives prices down, and instead seeks to ‘engage customers on more than just price’. It does this by offering a total package comprising consultancy services, design, manufacture, installation and maintenance for all industrial cooling and heat pump solutions. Increasingly it also supplies ancillary features such as energy efficiency monitoring systems. The company’s value proposition is based around its design and engineering skills, innovation and close engagement with the end-user. Barr + Wray provides a second example of this approach. The company began as filtration engineers but have now moved into the design and installation of swimming pools and health spas in hotels and leisure resorts. Barr + Wray’s value proposition is its project management skills in organizing and coordinating a wide array of suppliers. It developed this model in response to the decline in its original business selling specific products (pumps and filtration equipment). Like Star, Barr + Wray recognize that they are not the lowest cost provider and so seek to engage with potential customers on more than simply price.

The final case is Goals Soccer Centres, another AIM-listed company, which has created a network of more than 30 five-a-side centres across the UK and is currently expanding into the USA. It has positioned itself as distinctive from the ‘beer and football’ model of its competitors.  Its business model is based around three components. First, their centres are located on premier sites with a population catchment of at least 150,000 and in accessible locations. This ensures high utilization. Second, they invest substantially more than their competitors (£2.3 million per centre compared with £1.5 million) to provide high-quality ‘next generation’ facilities comprising the latest artificial pitches designed in collaboration with manufacturers to their specification (rather than bought off the shelf) and high-quality facilities including floodlights, superior changing rooms, licensing lounge, 9-14 pitches and car parking. This generates high returns. Third, they offer a superior service in the form of a bespoke IT booking system, support for leagues, Football Association qualified referees, and affiliation with Football Associations, features which create a competitive advantage, justifying a price premium. The company uses yield management pricing. With this model, Goals derives most of its revenue (over 75 percent) from football, with the rest from food and drink, in contrast to its competitors, who typically rely on food and drink for half of their revenues. The company’s biggest problem is finding affordable sites. It therefore focuses on sites with lower values because of restrictions on their use, such as school campuses where it can partner with local authorities, offering school access during off-peak hours.

Conclusion

The business model attracts relatively little attention in discussions of business competitiveness and growth. However, these cases highlight the centrality of the business model to the underlying competitiveness of high-growth companies, creating product and service differentiation which enables then to compete on the basis of non-price factors. Entrepreneurs, in conjunction with their advisers, therefore need to consider whether their own business models are ‘fit for purpose’. 

Notes

[1] Details of the full study are as follows: C Mason and R Brown (2010) High Growth Firms in Scotland, October 2010, Hunter Centre for Entrepreneurship, University of Strathclyde, Glasgow and Scottish Enterprise. [Online] http://www.scottish-enterprise.com/news/2010/11/high-growth-firms-could-be-key-to-economic-success.aspx

[2] High-growth firms were defined using the OECD definition: enterprises with average annualized growth in employees or turnover greater than 20 percent per annum, over a three-year period, and with more than 10 employees at the beginning of the observation period, should be considered as high-growth enterprises. The observation period was 2005-08.

Professor Colin Mason is based in the Hunter Centre for Entrepreneurship at the University of Strathclyde in Glasgow, Scotland where he engages in research and teaching around the theme of entrepreneurship and regional development. His specific research is concerned with the availability of venture capital for entrepreneurial businesses. He has written extensively on business angel investing and has been closely involved with government and private sector initiatives to promote informal venture capital, both in the UK and elsewhere. He is the founding editor of the journal Venture Capital: An International Journal of Entrepreneurial Finance (published by Taylor and Francis Ltd) and a consulting editor for the International Small Business Journal (Sage). Email: colin.mason@strath.ac.uk

Dr Ross Brown is based in the Strategy and Economics Directorate at Scottish Enterprise where he is responsible for strategic research within Scottish Enterprise. His main research interests are in the area of entrepreneurship, innovation and business internationalization. He has undertaken research and consultancy projects for research councils, regional and national governments, and international bodies such as OECD and European Commission. Email: Ross.Brown@scotent.co.uk

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