In my previous blog post I highlighted that digital business models have a fundamentally different cost structure than most traditional models – with a key difference being the low cost of revenue. Low cost of revenue in turn means low marginal cost, i.e. once everything is up and running, it doesn’t cost much more to serve additional customers.
Extremely low marginal cost has very interesting implications.
Unprecedented Freedom in Business Model Design
OK, living in the city where Porsche and Daimler are headquartered, I need to ask this: Have you ever wondered why car companies do not give away their entry level model for free – and just live off customers who pay to upgrade to the premium models? Or give free cars to students – to get them tied to the brand? It sure would help build market share, wouldn’t it?
Well, I suppose you never wondered about that – it’s clear to everyone that car companies cannot afford to give away cars to the majority of their customers. That’s simply not sustainable because cars are expensive to produce.
But with a digital business model, it’s possible to give away some products for free. That’s exactly what many software companies or Internet service companies do: free or heavily discounted software licenses for students. Free basic accounts on LinkedIn or Xing that are used by more than 90% of the user base – less than 10% of users upgrade to the premium packages and pay an annual fee.
Companies with digital business models can afford to do this: because of the low marginal cost, it doesn’t cost a lot to serve one (or many) more additional customers. That’s the freedom in business model design that digital business models afford.
Sales Growth Drives Profit Margin Expansion
That sure is a nice piece of investor-speak. And it’s about a very beautiful phenomenon … I’ll get to that in a moment.
Let’s first look at the impact of revenue growth in a traditional business model: with high cost of revenue, as revenue grows, operating profits and net profits grow roughly in proportion to revenue. Perhaps they grow a little faster, i.e. the profit margins become a little bigger, as you benefit from economies of scale: unit costs fall due to increased efficiency in mass production or distribution and because you’re getting higher volume discounts for the parts you buy. But profit margins won’t skyrocket.
The situation is very different for digital business models: due to low marginal cost, once you break even, i.e. your total costs exceed your revenue, then something wonderful happens: “Every additional dollar of revenue drops straight to the bottom line” as I once heard an investment banker phrase it. That’s a little bit exaggerated, but it gives the right idea.
Let’s look at two scenarios to understand this better:
I have used again the prototypical cost structures of two mature companies, one with a traditional business model and one with a digital business model.
Now, let’s assume a revenue spike of +20% in both cases. This is not entirely unreasonable – it can easily happen for a quarter in companies that have a strong end-of-the-year or holiday season business.
Since it is a short-term spike, this does not materially affect the “fixed” costs of R&D etc. In the traditional business model with the high cost of revenue, only a quarter of the additional revenue drops down to the operating profit line and the operating margin increases by 3 percentage points – from 7% to 10%.
In contrast, for the digital business with low cost of revenue, three quarters of the revenue increase drops down to the operating profit line and the operating margin increases by 7.5 percentage points – from 30% to 37.5 %.
In the digital business model, we see a much higher margin increase with a revenue spike.
The Opportunity for Margin Expansion Drives High Valuations
The valuation of a company, i.e. how much people would pay to buy the company, is not so much driven by the company’s revenue, but more by the profits a company generates.
Let’s assume we have two companies that generate the same revenue, but one of them regularly generates 5% net profit and the other one generates twice as much net profit (i.e. 10%). Then, assuming everything else is the same, the second company should be twice as expensive to buy as the first one.
Now, to make things even more interesting, valuation is actually driven not by today’s profits, but by profits expected in the future.
That’s why growth companies tend to have higher valuations: let’s assume two companies generate the exact same revenue and net profit today and they have the same business model and cost structures. But one is showing higher growth rates than the other. Assuming that both companies continue along their historic growth trajectories, then the faster-growing company will generate higher profits in the future than the slower-growing company. Based on this assumption, the faster-growing company will get a higher valuation today.
That explains why growth companies with a successful digital business model can get very high valuations: the company is growing its revenue, and up to a certain point, the associated profit is growing even faster than the revenue – that’s the margin expansion part. This leads to very high valuations.
Potential for High Valuation Makes A Company Attractive for VCs
It is no coincidence that the venture capital (VC) industry exploded along with the rise of digital business models. Investing in new ventures is risky and it is an accepted fact of life in the VC industry that the majority of investments performs just so-so, and some investments will be complete failures.
To make up for this, VCs need some investments that succeed spectacularly. If for example 70% of a VCs portfolio generates little return and 20% of the investments are lost entirely, then the remaining 10% of investments need to make up for all of the rest.
Therefore, VCs can invest only into companies that stand a reasonable chance of becoming such a star. This clearly favors companies with digital business models – who also have the potential to become big enough to go substantially beyond the break-even point and get well into the high-margin territory.
Digital business models are characterized by low marginal costs. This makes new business models feasible, e.g. the freemium business models, where the majority of users of an Internet service uses a base level service for free – and only a small minority of users pays for a premium subscription.
Once a company with a digital business model passes the break-even-point, revenue growth drives profit margin expansion, up to profit margins that are unheard-of in traditional business models, for example, net profits of up to 30%. This dynamic fuels high valuations – especially during the time period when the company is still growing fast, but is already demonstrating that its margins are improving.
This in turn explains why industries that enable digital business models (software, Internet, mobile apps, …) are very successful at attracting venture capital.
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