Understanding Business Models

How does a business make money and continue to operate? That is what a business model is.

It might not sound like personal finance, but understanding business models gives you an edge as a consumer, as an employee, and as an investor. Serious consequences for corporate executives who lie can often translate into insight for you during your interactions with various businesses. Since public companies have an obligation to report certain economic data a, we hear about many things like earnings reports and the like that can impact the stock market.

Understanding a business model is important because it gives you information that can help you determine if a company will continue to exist in the future. Or, if the company is doing well, it might help you understand why that is the case. Business models and analysis are not just for those fancy guys with suits on Wall Street. It is for the average person because it makes us smarter workers, employers, and consumers.

Types of Money

This week I read through an interesting discussion about pentamillionaires and throughout the discussion, there was a simple explanation of how rich people get that way. One of the ways that this happens (and is quite common), is that rich people started one or more of their own businesses and employed one of the techniques listed below.

Licensing

Licensing is a common idea when it comes to intellectual property (IP for short). IP is often thought of as something like a book where there are fees for every copy produced or used. This means that there are options of this type for almost any creative work. Software, music, and art goods that can have options for people that have talent in a particular area. Writing, however, is something that almost anyone with a passion for a topic and a desire to practice and get better can do with just a little bit of dedication.

Transaction

In very specific cases, licensing can be broken down to the transaction level. For example, in a more traditional form of licensing, people buy a copy of microsoft&t office for example and are able to use it forever after paying the one time fee. Add-on programs and upgrades can cost money and therefore the fees are a one time expense.

Transaction costs on the other hand are a way to gain income based on the actual usage of the product. This is the case with song royalties as well as some types of software that is priced per transaction. Let’s say you have some sort of online financial program. Then you were to import the content into your program and each line cost a certain amount of money. This means that there will be a cost for each individual transaction. There is a large upside and downside to this type of model. For an upside, there is a great chance to make a significant sum of money if the product is very successful. But in the case that the product doesn’t do well or doesn’t have a significant amount of use, the income will be significantly less.

Subscription

In essence, this is the same as a one-time licensing fee. Often this is not derived from the cost of an item you have obtained, but rather from the services that you will be authorized to access for a particular amount of time in the form of a subscription. Software support contracts work this way, as do magazine subscriptions. A service is provided for a certain amount of time and then afterward is stopped unless a renewal deal is struck. The key for this type of business, of course is to keep the quality of the service fairly high so that the value will be apparent when people want to renew services.

Advertising/Sponsorships

In some cases, high value items like news, software, or tools can be provided for free to end users. However, in these cases, the costs that are incurred by the company that produces the product are offset by the people who are paying to have their products advertised and sponsored along with the product. This ends up being acceptable for the users in general since they know that they will get something of value as a result of dealing with this advertising. The key to this type of business model is to make sure that people feel comfortable with the advertising. On the web, it might be making sure that the ads are appropriate for the audience and are clearly marked. In magazines, it might be making sure that the ads are brightly colored and readable. In any case, advertising and sponsorships are one of the more common ways that the costs of the services you consume are covered.

Regardless of your place in the economy — consumer or business owner — it is critical to understand the business models of the firms you interact with. Understanding where the money comes from and where the money is going can give you real insight into the workings and priorities of the company.