To extract value from an innovation, a start-up (or any firm for that matter) needs an appropriate business model. Business models convert new technology to economic value.

For some start-ups, familiar business models cannot be applied, so a new model must be devised. Not only is the business model important, in some cases the innovation rests not in the product or service but in the business model itself.

In their paper, The Role of the Business Model in Capturing Value from Innovation, Henry Chesbrough and Richard S. Rosenbloom present a basic framework describing the elements of a business model.

Given the complexities of products, markets, and the environment in which the firm operates, very few individuals, if any, fully understand the organization's tasks in their entirety. The technical experts know their domain and the business experts know theirs. The business model serves to connect these two domains as shown in the following diagram:

Technical Inputs

Business Model

Economic Outputs

A business model draws on a multitude of business subjects, including economics, entrepreneurship, finance, marketing, operations, and strategy. The business model itself is an important determinant of the profits to be made from an innovation. A mediocre innovation with a great business model may be more profitable than a great innovation with a mediocre business model.

In their research, Chesbrough and Rosenbloom searched literature from both the academic and the business press and identified some common themes. They list the following six components of the business model:

1. Value proposition - a description the customer problem, the product that addresses the problem, and the value of the product from the customer's perspective.

2. Market segment - the group of customers to target, recognizing that different market segments have different needs. Sometimes the potential of an innovation is unlocked only when a different market segment is targeted.

3. Value chain structure - the firm's position and activities in the value chain and how the firm will capture part of the value that it creates in the chain.

4. Revenue generation and margins - how revenue is generated (sales, leasing, subscription, support, etc.), the cost structure, and target profit margins.

5. Position in value network - identification of competitors, complementors, and any network effects that can be utilized to deliver more value to the customer.

6. Competitive strategy - how the company will attempt to develop a sustainable competitive advantage, for example, by means of a cost, differentiation, or niche strategy.

Business Model vs. Strategy

Chesbrough and Rosenbloom contrast the concept of the business model to that of strategy, identifying the following three differences:

1. Creating value vs. capturing value - the business model focus is on value creation. While the business model also addresses how that value will be captured by the firm, strategy goes further by focusing on building a sustainable competitive advantage.

2. Business value vs. shareholder value - the business model is an architecture for converting innovation to economic value for the business. However, the business model does not focus on delivering that business value to the shareholder. For example, financing methods are not considered by the business model but nonetheless impact shareholder value.

3. Assumed knowledge levels - the business model assumes a limited environmental knowledge, whereas strategy depends on a more complex analysis that requires more certainty in the knowledge of the environment.

Business Model for the Xerox Copier

Chesbrough and Rosenbloom illustrate the importance of the business model with a case study of Xerox Corporation's early days in the copy machine business with its Xerox Model 914 copier. (Before changing its name to Xerox Corporation, the company was known as the Haloid Company and then Haloid Xerox Inc.)

The Model 914 used the relatively new electrophotography process, which is a dry process that avoids the use of wet chemicals. In seeking potential marketing partners, Haloid repeatedly was turned down by the likes of Kodak, GE, and IBM, who had concluded that there was no future in the technology as seen through the lens of the then-prevalent business model. While the technology was superior to earlier copy methods, the cost of the machine was six to seven times more expensive than alternative technologies. The model of selling the equipment below cost and making up the difference by large margins in the sale of supplies was not viable because the cost of the supplies was about the same as that of the alternatives, so there was little room to maneuver.

Xerox then decided to market the new product itself and developed a new business model to do so. The new model leased the equipment to the customer at a relatively low cost and then charged a per copy fee for copies in excess of 2000 copies per month. At that time, the average business copier produced an average of only 15-20 copies per day. For this model to be profitable to Xerox, the use of copies would have to increase substantially.

Fortunately for Xerox, the quality and convenience of the new copy technology proved itself and companies began to make thousands of copies per day. As a result, Xerox sustained a compound annual growth rate of 41% over a 12 year period. Without this business model, Xerox might not have been successful in commercializing the innovation.

The Entrepreneurial Advantage

Chesbrough and Rosenbloom observe that a successful business model such as that of Xerox tends to build momentum and the company becomes confined to its successful model. However, new technologies often require new business models.

Because start-up companies are free to choose or develop a new business model, in this regard start-ups have an advantage over more established firms. In addition to the risk incurred in the technological and the economic domains, an unproven business model adds additional risk, and entrepreneurial ventures usually are more prepared to accept this risk than would be a large, well-entrenched firm.

In fact, many venture capitalists see themselves as investing in a business model. Consequently, it often is the VC that pushes for a change in the business model when it becomes apparent that the original model is not working.

Recommended Reading

Henry Chesbrough, Open Innovation : The New Imperative for Creating and Profiting from Technology

In Open Innovation, Chesbrough explains how many of today's successful business models leverage the innovations of others. Chesbrough discusses in detail the concept of the business model using real-world examples including the spin-offs of Xerox and more recent examples such as Millennium Pharmaceuticals.