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If you’ve ever watched Dragon’s Den or Shark’s Tank, you know that the most common concerns the Dragons and Sharks have with any potential investment are the business model, revenue growth, customer acquisition cost, and scalability. At the most basic level, a business will be successful if it’s based upon a model that can increase profits over time while limiting costs. That’s where understanding exponential and linear business models becomes crucial.
If you’re an entrepreneur starting a new business or wanting to take it to the next level, this article will help you decide on the best type of business model for your situation. Using recent IPO scenarios from WeWork and Peloton, we’ll take you through what makes a company investment-worthy based on growth potential.
The linear business model
The vast majority of business owners develop their company with a linear model. Also referred to as a pipe model, everything occurs sequentially and flows in the same direction.
Linear businesses use raw materials to produce something or offer a service, distribute it to consumers, and get paid for their products/services. Then, the business moves on to another client or consumer.
This type of business model is very intuitive, but a major drawback is that it can be very time consuming to continually and consistently attract new clients and customers.
WeWork’s linear business model approach
Founded in 2010, WeWork is one of the fastest-growing companies in America these days. They provide shared workspaces and networking events for startups, freelancers, and enterprises. But despite its fast growth and popularity among businesses, the company doesn’t have the same appeal to investors.
WeWork has been particularly successful in building its brand recognition. When many people think about companies who provide co-working spaces, WeWork is at the top of mind. It’s a real estate company that sells an appealing lifestyle and modern way of working with its hip decor and dynamic energy. But for investors, all the bells and whistles isn’t sufficient enough for serious consideration.
Case in point: Let’s take a look at WeWork’s IPO. Last year, the company was valued at $47 billion USD. Revenue was $1.5 billion USD in the first six months of the year. However, within that same time period, the company lost $904 million USD, which amounts to a 25% increase from the same period in the prior year. Some projections say that the company loses $219,000 hourly!
WeWork operates in 111 cities and most of its concentration is in high-priced real estate markets like New York and San Francisco. That means the company pays significantly more per square foot than its competitors, who are spread throughout the country and are able to provide more competitive rates because of the lower operating costs.
WeWork doesn’t own their own real estate and nothing is proprietary. Rather, the linear business model is basically negotiating cheaper annual rents for buildings and renting this space out to other businesses. However, this model only works when the economy is healthy. During a recession, companies try to cut back on as many expenses as possible, including office space. But WeWork would already have paid for long-term leases, so they would need to fill the space or risk experiencing significant losses. In the end, increasing sales also means increasing costs, with limited opportunity to scale.
Update: Since the publication of this WednesdayOneThing blog post, WeWork has experienced significant financial setbacks, further emphasizing the major challenges associated with scaling a linear business model.
The exponential business model
An exponential business model looks at the same key areas as a traditional business model, in terms of basic financials. The difference is that the goals are different in each type of model. With a linear business model, the goal is to have a controllable 10% increase in profits or a 10% decrease in costs. In an exponential business model, the goal is to reach 10x the growth in profit.
Taking your business model from 10% to 10X the growth rate isn’t just about about scaling. It also requires a new perspective in envisioning how your business can serve your target market. Peloton is a great case study on how a business can structure itself to achieve this degree of exponential growth.
Peloton’s exponential business model approach
Peloton is the first company to make cycling equipment with screens that enable users to join live and recorded fitness classes remotely. The digital fitness company is valued at $8.1 billion USD. Last year, sales grew 110% to $915 million from $435 million USD. Meanwhile, its 2019 net loss widened to $245.7 million USD, up from a net loss of $47.9 million in the prior year. Yet, despite the increases in losses, there is a lot of growth potential for Peloton in a way that is not achievable through WeWork’s business model.
Peloton was wise in not branding itself as a cycling company. Instead, it refers to itself as a tech company. Peloton’s offerings go beyond just selling cycling equipment. Their stationary bikes come equipped with a tablet that allows riders to live-stream classes or watch recorded sessions conducted by top-rate instructors. This concept can easily be expanded into other exercise markets. In fact, the first expansion has already taken place into treadmills.
With Peloton, all the technology they sell is proprietary, including their hardware, software, and the content they create. With their multi-tiered revenue stream model, Peloton has been able to expand its business in a way that a linear-based business could only dream of.
Unlike competitors like FlyWheel and SoulCycle, where customers need to physically attend location-specific studios, Peloton has created a new model for this market. Using an in-home bike or treadmill, subscribers can achieve all of their fitness goals and become a member of an engaging community without going anywhere. For Peloton, the business model is highly scalable without being susceptible to the boundaries of physical spaces and unpredictable rent.
When structuring your business, take into consideration your short- and long-term business and personal goals. For some, the traditional linear business model makes sense, but if you’re looking to make your business attractive to investors, they will be interested in that 10x growth factor. Taking into consideration your ultimate end goals will help you determine if an exponential vs. linear business model is the best fit.
If you’re a direct-to-consumer e-commerce business, here are some more tips on how to make yourself attractive to VCs.
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