A digital business model might be defined as a model that leverages digital technologies to improve several aspects of an organization. From how the company acquires customers, to what product/service it provides. A digital business model is such when digital technology helps enhance its value proposition.
- A few myths around digital business models
- Start simple, make it viable
- A model for each stage
- A new way of doing business
- Leveraging on consolidated models
- Amazon‘s flywheel? Part product, part distribution
- Are digital businesses fragile?
- Digital business models types
- It’s all about mixing things up to find your own recipe
A few myths around digital business models
We all like to think of digital business models as innovative in their own sake. However, in many cases innovation happens by combining aspects from existing business models to create a unique formula.
Not a single formula, but rather a recipe with ingredients to be tested
Almost like taking the existing ingredients, remixing them by using different quantities and cooking time, an “innovative” business model is often the results of those recombinations.
And it requires a lot of tweaking.
Digital is not just about the product/service
You create an ebook, sell it on the web and you call your business a digital business. Sure, that is a digital product but the fact that your product is delivered digitally doesn’t make it a digital business.
There are few other things to take into account.
Digital is not just about distribution
You build a website, call it a platform, and you have a digital business. However, a website is just like a physical windowshop, in order for you to create a sustainable flow of customers/partners/users you need to make it scalable.
That requires to understand what models fit best the potential customers/users identified.
Start simple, make it viable
If you look at a business model like Google, you think of it as a complex platform since the start. However, it took years before Google would develop all the building blocks (former Google AdWords, and Adsense) to make it extremely scalable.
Initially, Google was just closing advertising deals on its search pages leveraging on salespeople, just like a traditional organization. When Google finally built its two primary ads platforms (AdWords, now Google Ads and AdSense) its business growth picked up together with its traffic growth.
Before Netflix would become a viable streaming platform it took decades. And before that it was primarily a DVD-rental company. DVD-rental, in 2019, made up less than two percent of the overall Netflix revenues (interesting enough the company still reported over two million DVD members as of 2019).
Yet, when video streaming became technically viable, Netflix business model also evolved, thus making the company surf a different market (video streaming) rather than DVD rental.
A model for each stage
Amazon wanted to develop a way for third-party sellers to build their e-commerce on top of Amazon infrustructure (at the time that was called Merchant.com) to push on its mission to provide a wide variety of products.
While Amazon AWS is now a company within a company. That infrustructure helped Amazon build a more scalable business model and push to a different stage of growth, probably not possible without the contribution of AWS.
Yet, what would later become AWS only started to be developed in the 2000 (Amazon started in 1994). And only after a few stages of hypergrowth the company went through.
A new way of doing business
Therefore, building a digital business requires mastering new ways of looking at your business and they primarily move around a key pillar (your customers/users or those for which your service/product provides a clear advantage) and a few elements:
- Product/service: building a digital product/service requires a mindset that goes from something scarce, to something potentially unlimited. Digital product/service can also be quite expensive. Think at how platforms like Google have to spend billions to keep operating their digital assets by also investing in massive physical infrustructures (data centers). Yet those products often leverage network effects.
- Distribution: building a digital distribution means understanding the various channels existing on the web. New channels come every few years. But some of the channels you might want to take into account to enhance your digital business are email marketing (newsletter), search engines (Google, YouTube, DuckDuckGo, Bing, Yahoo), social media/discovery driven platforms (Google Disccover, Facebook, Instagram, YouTube), and creative media (TikTok) to mention a few.
- Value proposition: a digital business model value proposition can often be delivered by providing the upside without the downside. Think at how Google makes you search for anything without requiring you to bring an encyclopedia in your pocket.
Leveraging on consolidated models
As the story goes McDonald’s started to use a franchising model to grow its restaurant business, and it became over the 1960s a giant in the restaurant business (or real estate depending on the perspective).
McDonald’s leveraged on the existing “Speedy Service System” developed by the McDonald’s brothers (what we would later call “fast food”) which was an incredible process development able to provide an improved product at a faster pace.
The speedy system itself represented the application of the manufacturing process to the restaurant business. Later another important building block was added.
The franchising model really became widely applied during the 1920s and 1930s in the restaurant business. As new physical communication networks (in the US the Interestate Highway System) enabled people to move long distances with their cars.
Later on, Ray Kroc would apply in its most aggressive form the franchising model (different formats already existed centuries before) to the McDonald’s existing operation to create one of the most scalable restaurant business in the world.
Yet, franchising combined with a product delivered differently (the “speedy system”) making up a whole new experience, that made it a new business model: the heavy franchised McDonald’s business model.
Amazon‘s flywheel? Part product, part distribution
Not so different from the franchising model in the physical world, the affiliate model would enable a digital property to leverage on the Amazon‘s brand and sell its products and get a commission in exchange.
Affiliate marketing today sounds as old as the web (indeed it is), yet back in the late 1990s that was one of those innovation (which idea was old yet applied to the web) that helped build some of the tech giants we know today.
Are digital businesses fragile?
Many of the new digital business models try to apply old or new philosophies to the web. For such reason they might work in the short-medium term (5-10 years), but prove extremely fragile in the long-run (20-50 years).
Thus, it’s important when building a digital business to know its advantages but also its drawbacks.
And a way to prevent a digital business to fail is to have a buffer (that is also why tech giants sit on large piles of cash as a buffers).
Digital business models types
- Hidden revenue
Open source model
An open source model makes software free to access, and it generally gives the ability to a community of programmers to contribute to it. Those two ingredients are essential. Free makes it spread very quickly. And the community side of it is what eventually determines its success.
An open source isn’t a model on which companies can leverage to build a sustainable business model. Companies like Red Hat, for instance, make money by charging premium subscriptions and for training and services associated with its open source software.
Indeed, in 2018, Red Hat generated over $2.9 billion in revenues, of which, $2.57 from subscriptions and $346 millions from training and services. Red Hat isn’t the only possible way to monetize an open source software.
Going back to Red Hat case study by looking at its annual report Red Hat explains its business model as it follows:
Development. We employ an open source development model. The open source development model allows us to use the collective input, resources and knowledge of a global community of contributors who can collaborate to develop, maintain and enhance software because the human-readable source code for that software is publicly available and licenses permit modification.
Licensing. We typically distribute our software offerings under open source licenses that permit access to the software’s human-readable source code.
Subscriptions. We provide our software offerings primarily under annual or multi-year subscriptions as well as ondemand through our certified cloud and service providers (“CCSPs”).
- quick and effective development via a global community of qualified contributors which are not on the company’s balance sheet
- great distribution via free licensing of its software
- paid subscriptions for premium and enterprise customers
Building up an open source-based business model isn’t simple and it’s success highly depends on the ability of the project to engage the community of developers and contributors in working on the source code to improve it and make it very valuable.
Also, such a model where a free service does allow strong marketing for the product. But it doesn’t necessarily translate in revenues for the company. For instance, Red Hut in 2018 employed $1.2 billion in sales and marketing expenses to distribute its paying subscriptions.
That represented 41% of its total revenues which comprised “primarily of salaries and other related costs for sales and marketing personnel, sales commissions, travel, public relations and marketing materials and trade shows.“
The free model has become quite pervasive on the web. Starting from Netscape going on, companies have built great products, released them for free with the hope that once enough people would get used to them, monetization would not be an issue.
While this model worked pretty well for products that scaled up quickly, amassed investments to sustain their infrastructure in the short term, and then found a monetization strategy.
Companies like Google and Facebook have started in this way. They released a free service to a larger and larger user base. Attracted the first angel investors, then venture capitalists they had to then quickly turn to the advertising model to monetize their users, to avoid being left without cash and investors.
Thus, while a free service allows to scale up at a marketing level, the company will still have to figure out how to monetize the service provided. There are usually a few routes:
- A basic version of the product, and a more advanced paid version (freemium model)
- One side gets the service for free, and the other side finances it (asymmetric model)
- Training materials or info products adjacent to the core topic of the product (educational model)
- A free basic service, and a more advanced paid service (usage model)
- A job board that connects talented people with employees (job board model)
Those are just some examples of how an open source model can be monetized.
The freemium model has gained in popularity in the last decade. The reason is simple; this model allows a high virality growth. Cases like Dropbox, MailChimp, Spotify, and many others have created viral growth thanks to these models.
At its core, a freemium model has a free version available to anyone, with no friction. Prompts within those free services to switch to paid subscriptions to get more volume, no advertising or more data.
For instance, Spotify offers a free limited service, advertising-supported. But if users decide to get the premium service, they can listen to music without interruption from advertising and also download music to listen offline.
Dropbox instead, makes you use more space with a premium service. And MailChimp gives you advanced features and the ability to handle more subscribers in your email list.
If you opt to this model, you need to make sure you have the following:
- A strong enterprise customer base
- An optimized conversion funnel to switch free users in paid ones
- A robust technological infrastructure that can handle a broad base of free users
This model can be very powerful as it carries a few built-in advantages:
- A loyal user base
- A continuous stream of predictable revenues
- A more predictable sales pipeline
In short, many companies are “subscribing” to this model as it allows them to build a sustainable revenue stream over time. However, it is essential to remark that creating this kind of model isn’t a simple task.
Indeed, companies like Netflix and Spotify spend billions of dollars in producing original content that can make those subscribers wanting to renew their plan.
Usually, a model that relies on a subscription also requires essential investments in infrastructures, as what makes the services offered through this model is the ability of those platforms to know precisely what to watch or listen to next.
Also, you’ll need to build a process skewed toward a great customer experience to minimize churn rates and improve the lifetime customer value. When your CAC or customer acquisition cost is higher than the lifetime value of your customers, your business will soon be bankrupt.
The Web finally allowed people to consume content at their own pace and schedule. What mass media, like TV and Radio, didn’t accomplish, the Web did. An on-demand consumption allows people to have access to the content at different time intervals.
Also, it doesn’t make sense any longer to have a single product or service offering for anyone at scale. Thanks to the on-demand model
Yet other services, like Uber, and Lyft also built their success by leveraging on the on-demand model. As technological platforms allow people to interact instantaneously, it makes possible those kinds of services.
The on-demand model can be monetized in several ways. From subscriptions to fees for each transaction on a platform.
The critical ingredient is to create a smooth user experience, in which you barely realize there is someone in the backend manufacturing that experience.
Peer-to-peer, two-sided marketplace
A peer-to-peer, or two-sided marketplace often fall into the chicken or the egg dilemma, where the marketplace to work needs both sides to interact.
Yet the paradox is that to have demand on the platform you need a continuous generated supply. At the same time to have supply you need to create demand.
Imagine the Uber case; the platform works as soon as there are enough drivers on the road to offer an on-demand and convenient service when riders need it.
However, drivers want to drive at their convenience and when the fees are high enough to justify their effort. Therefore, the peer-to-peer marketplace usually faces several challenges in making sure the supply side is served adequately to justify demand.
Uber, Airbnb, Etsy all face this issue. For instance, Uber uses several strategies to enhance the supply of drivers on its platform by using dynamic pricing strategies, like surge pricing.
You can appreciate the importance of drivers supply for Uber by the fact that companies like HyreCar have built their whole value proposition based on the supply scarcity on Uber.
One of the first companies that proved the web wasn’t made just of connected computers but of people ready to purchase physical stuff on it was Amazon. Started as a book store the company soon branched out to sell music and related products. Until it became the everything store!
Today an e-commerce business model is taken from granted and is among the most used digital business models.
If Amazon had proved that the web could become an everything store, a company that changed the way media could be consumed was Google. Rather than just having to type a website address in a browser, people could search for anything they wanted.
Google made all its services, and apps completely free. While on the other side it monetized the data captured via its search engine pages with an advertising network called AdWords (now Google Ads).
When Google IPOed back in 2004, it showed to the business world how powerful its digital advertising business was. Indeed, in a matter of a few years, Google passed the billion dollars mark. In 2017 its advertising business passed the hundred and ten billion dollars mark!
To make sure, while a digital advertising business might be easy to set up, it’s not an easy one to run and make profitable. Unless you’re Google or Facebook with their dominant advertising marketplaces, you won’t be probably able to make money via advertising alone unless you have a very large users’ base.
Hidden revenue generation model
Hidden revenue generation is about making money while the people that most use your service barely realize that. A great example is Facebook (and Google).
If you ask an average Facebook or Google user, she won’t know how the company monetizes. That’s because those companies have invested massive resources in creating this kind of experience.
It’s all about mixing things up to find your own recipe
Each model we saw above isn’t a complete business model that can be applied entirely to a company.
Often business models are the fruit of the combination of several parts. For instance, Airbnb and Uber are on-demand, peer-to-peer marketplaces.
Many businesses we analyzed throughout the article use several models to build a successful business model.
For instance, Google leverages on an open source model for some of its products, while it monetizes its core product (the search engine) with a hidden revenue model and it also leverages on making its products free to large masses to gain traction quickly and make of its products a standard!
Other handpicked resources:
- Business Strategy: Definition, Examples, And Case Studies
- What Is a Business Model? 30 Successful Types of Business Models You Need to Know
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- Blitzscaling Business Model Innovation Canvas In A Nutshell
- What Is a Value Proposition? Value Proposition Canvas Explained
- What Is a Lean Startup Canvas? Lean Startup Canvas Explained
- How to Write a One-Page Business Plan
- The Rise of the Subscription Economy
- How to Build a Great Business Plan According to Peter Thiel
- What Is The Most Profitable Business Model?
- The Era Of Paywalls: How To Build A Subscription Business For Your Media Outlet
- How To Create A Business Model
- What Is Business Model Innovation And Why It Matters
- What Is Blitzscaling And Why It Matters
- Business Model Vs Business Plan: When And How To Use Them
- The Five Key Factors That Lead To Successful Tech Startups
- Business Model Tools for Small Businesses and Startups
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