A business model is the way that a company or industry makes money and delivers value. At its simplest you can say “We do X for Y and get paid Z”. Most of the time we see business models as stable and permanent. Step back though and business models appear. grow, stabilise and eventually decline and disappear. A business model because it generates revenue can be considered as an asset and so this article is all about the idea of business model depreciation and why it is important.
Many managers are familiar with the idea of depreciation. When an asset is purchased it appears on the balance sheet. Over a period of time it’s value depreciates as it wears out due to use and age. A business needs to factor the cost of depreciation into its accounts and also needs to plan for the replacement of the asset in time.
Business model depreciation extends this concept from the realm of accounting to business strategy.
Business Models Don’t Last Forever
No business models last forever. In some cases it may seem that they do but that is often due to the short sightedness of our experience. So for example the modern electricity supply business model has been around since the 1920’s.
In the 1920’s there were lots of small scale power stations delivering electricity to the immediate surrounding area. With the invention of the steam turbine it became economical to run much larger power stations, and regulation in the UK supported the creation of the national grid which allowed power stations to be large, separated from the towns they served and connected by high voltage transmission cabling. That business model has existed for over 100 years and no one now can remember anything different.
The reality is a lot different. IBM, for example has run through half a dozen different business models. The original IBM made punch clocks, then moved to tabulating machines, then computers, then mainframes, then PCs, business systems and currently AI. In almost all of these cases the business model that drove the company and created its profits lasted just a few decades.
In other industries, for example in some segments of digital marketing, profitable business models can only exist for months. They are created by the emergence of new technology, and then closed as the technology evolves or fails. Where I live the triads had a very profitable business model pirating CD’s until people stopped buying CDs alltogether.
Business model depreciation is thus an attempt to capture this impermanence in business models. It says that at some point the main source of a company’s, or industry’s, profits will cease to exist. The industry will thus have to radically reinvent itself in order to survive.
Taxis: Horse Drawn and Petrol Driven
If we look back to the turn of the 20th century the majority of taxis in London were horse and cart style taxi cabs, often called hackney or hansom carriages. These were supplied by dealers in a similar way that modern car dealerships work.
One of these dealerships (Mann and Overton) saw that the motorcar was the way of the future and commissioned a car company (Austin) to create and internal combustion model for it to sell. In doing so Mann and Overton destroyed the horse and carriage supply business model and replaced it with a new one, driven by the internal combustion engine, that lasted for another 100 years until Uber and ride sharing then disrupted that business model driving Mann and Overton into bankruptcy.
If you have a successful business model, whether as a player in a concentrated industry, or highly fragmented one, your future revenues are limited.
Traditionally businesses have considered that R&D and new product design have been the way to solve this problem. One of my great uncles was awarded the legion d’honneur by the French government for his contribution to the development of the vacuum tube. Less than a decade later his life’s work had been abandoned as the vacuum tube was replaced by the transition and the age of the computer.
R&D and product development is often incremental. It’s delivered by managers whose role is to extract the most value from the market as it exists now and will evolve in the next few years.
It takes now account, futurists at some major companies excluded, of how the industry or sector can rapidly transform in the next few years.
Bankruptcy: Slow then Fast
One final point before we delve further into business model depreciation. Hemingway famously asked in the Sun also Rises:
“How did you go bankrupt?”Ernest Hemingway, The Sun Also Rises
Two ways. Gradually, then suddenly.”
Business models seem to often work for a very long time and then fail suddenly
This drawing shows user adoption of a new idea, adapted from Geoffrey Moore’s Crossing the Chasm. Many business models have a similar evolution. They start slowly with a few early adopters. Then they achieve mass market adoption and epentration. Then there can be a long plateau. This might be slowly growing as managers find was to make it more effective. It may be slowly shrinking as it gets battered by external forces.
As it comes to the end of it’s life we then see it slowly becoming weaker until it very rapidly collapses. The underlying economic or value logic no longer exists and like a rotten log when stepped on nothing remains to support it.
A few examples. Kodak, famously saw that the age of film was coming to the end, and was unable to do anything about it and was destroyed. Nokia and Blackberry had their business models destroyed in a couple of years by the new smartphone business model that Apple and Google created. Friendster and Yahoo saw their business models destroyed in months by Facebook’s timeline and Google’s adwords based business models respectively.
What Happens when an Old Business Model is Displaced?
When we look at things from a historical perspective the amount of value in the existing business model seems to be fairly irrelevant. In most case the incumbent business model had made its owners fortunes and continued to do so. For major industries there were significant assets on the balance sheet.
However when a new business model displaces the old one significant new value is unlocked, often so significant, that the previous model seems small and outdated. As we look back to telephony in the 1930’s or electricity generation in 1900 the value of those industries in today’s terms is insignificant. Business model innovation is incredibly powerful. Both at creating new industries and destroying or emasculating old ones. Who would now think that the steel industry once created one of the largest fortunes in the world?
What should managers do?
One of the key issues for management is that they are often able to see the new business model. They have the knowledge and the resources to exploit it. They do not act. Why not?
Simply put, adopting the new business model will require them to actively participate in the destruction of their existing markets and revenue streams. That’s an anathema to the modern MBA manager who has been schooled to grow revenue and cut costs. Managers focus on improving business model performance not changing it
It’s also a big challenge to justify this to shareholders. Are managers shirking their fiduciary duty to shareholders? Can they be sued for doing so?
This is the fundamental reason why putting a value on the business model and then depreciating it is so important.
Measuring Business Models
Using the model above we can say:
- The business model generates profits of $10 billion/year
- It has a life expectancy, in plateau phase, or 25 years
- When it fails it will fail over a period of 5 years and we will see revenue collapse by 90% if we do nothing.
- The business model that replaces it will likley generate profits of $50 billion/year after 15 years
So if we depreciate the existing business model and capture the depreciated share of profits then the business is in a powerful position to transition from one business model to another.
Issues with Business Model Depreciation
My expertise is not in financials and accounting. However, I’m quite sure that this does not fit comfortably into GAAP and financial statements
And yet it seems that managers as shareholders agents have a clear responsibility to ensure that shareholder value is not destroyed by running an existing business model into the ground, or failing to transition to a new model for fear of damaging existing revenues.
Using an approach like business model depreciation means that the business can reserve some of the value in preparation for this change.
Again there are big problems, because this is a paradigm shift in how we approach the business of running a company through multiple business model cycles.
If you have a cash pile should you invest it? But if the businesses you invest it isn reinforce rather than subvert the existing model you are no better off
Keeping a business model war chest in financially inefficient and means that you are leaving money on the table from the exploitation of the existing business model
The Value of Business Model Depreciation
These are challenges. And yet the clarity of having a clear conception of how long the existing business model has lasted, how long you expect it to last, and consideration to financing the transition from the old and the new is exceptionally powerful