How Digital Business Models are Truly Special – Funding Options

In two previous articles, I discussed that digital business models are characterized by a cost structure with low marginal cost, and the implications of low marginal cost: more freedom in business model design, sales growth driving margin expansion, and potentially high valuations. The potential for high valuations makes digital business models especially attractive for venture capital (VCs).

On the other hand, digital business models often require upfront funding, and because of their cost structure, that funding typically can be obtained from VC-type investors only.

Traditional Business Models Can Often be Funded Through Loans

Traditional business models typically have high cost of revenue, i.e. most of each dollar of revenue is directly spent on buying or making the goods or services that are the source of revenue.

Examples for cost of revenue include

  • labor cost and cost of parts bought for a business that manufactures goods – e.g. a manufacturer of furniture
  • cost of merchandise for a retail business – think WalMart
  • labor cost for labor-intensive services – such as SW support or consulting

Some traditional business models don’t require a lot of “front-loaded” funding, i.e. operating costs can be funded pretty soon from revenue. Consulting services are an example here: the biggest cost item is labor cost for the consultants – and assuming that the workforce is scaled up in line with customer demand and that the business model is fundamentally profitable, not a lot of upfront funding is required at all.

Another type of traditional business model does require upfront funding, but most of it goes into either buying tangible goods or it is labor cost to produce tangible goods. Think of establishing a retail business, where upfront funding is needed for furnishing the retail location and for upfront financing of merchandise. In this case, it is often possible to finance a significant part of the required upfront investment through loans, as the tangible goods have some resale value and therefore, can serve as collateral for the loan.

For these two types of business models, there is no need for venture capital, and these types of businesses are also not attractive for venture capital.

Just for the sake of completeness: there are other types of traditional business models which do require upfront investment that does not buy or produce tangible goods. For example, an R&D-intensive technology startup that intends to produce some innovative piece of hardware. Ultimately, due to the production cost associated with the hardware piece, this will have to be a traditional business model. But the upfront investment in R&D and business development cannot be funded through loans, as no tangible goods are involved that can serve as collateral for the loan. These startups need to rely on VC-type funding – just like startups with digital business models.

Ventures with Digital Business Models Typically Need to Rely on VC-Type Funding

As I explained in earlier posts, with digital business models, cost of revenue makes up only a small percentage of revenue, and the biggest cost items are usually of the fixed cost type, in particular R&D and sales & marketing. Unfortunately, these two cost items usually don’t produce tangible goods with significant resale value in case the business fails.

So there is nothing to serve as collateral for a bank loan – which is why startups with a digital business model are typically not eligible for loans at all. If a startup with a digital business model requires external funding, this funding needs to come from a VC-type of investor. By VC-type investor I mean anyone who is ready to fund digital startups in spite of the high risk associated with these types of investments: angel investors, seed funds, later stage VCs, growth funds, government-funded startup funds, crowd funding etc.

On the flip side, successful digital business models have the potential to generate high profit margins, and in the best case, they can yield them in a shorter time frame than other high-risk ventures, such as drug development. That’s why digital businesses are an attractive investment area for VC-type investors.

Conclusion

Digital business models are characterized by a cost structure with low marginal cost. This cost structure thing might sound like a technicality that is relevant to the bean-counters only. However, in reality this unique type of cost structure has wide-ranging implications – one of them in the funding area: on one hand, promising new ventures with a digital business model are highly attractive to VC-type investors. On the other hand, startups with digital business models are not eligible for loans and VC-type investments are the only source of external funding they can use.

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