Business leaders often neglect to critically question the sustainability of their business model and understand their inherent Business Model Risk. When a line of business, department, segment or product is going well the temptation is to rely on it more heavily for future revenue and earnings growth.
What follows is that in both the strategic planning and budgeting processes these areas are given higher targets and more resources to grow their businesses.
However, one of the many lessons from the Global Financial Crisis (GFC) – and in fact many case studies prior to the GFC – is that if it is ‘too good to be true’ it probably is. A fundamental structural flaw or weakness in the business model is often the key reason for previously successful areas either failing to be an engine of continued growth or suffering a collapse in earnings.
In the banking and financial services arena, there is a long list of ‘boom time’ products and sectors – energy trading, emerging markets bonds, subprime loan products, collateralized debt obligations, private equity, leveraged finance, and so on – that subsequently turned out to be unsustainable or unprofitable business lines. Failures were often attributed to ‘excessive risk taking’.
A more thorough analysis should be undertaken however. It is necessary to discriminate between excessive risk taking, cyclical business risk and other more serious structural flaws in the business model.
In the famous example of Enron, businesses grew rapidly and (at the time) prospered but were found to be wanting due to flawed business models and excessive risk taking.
Businesses that grew during the subprime era in the US – both retail banking and investment banking businesses – are also examples of flawed business models. It is now apparent that there was no assessment of Business Model Risk by many of the firms participating in the subprime ‘boom’.
Similarly, consumer electronics, media and related entertainment industries provide many examples of business models that have been made redundant over a short period of time due to rapid changes in technology. The suburban DVD rental outlet has become redundant in many countries due to the emergence of web- based downloading and viewing businesses, for example.
Whilst the above can be considered extreme examples of business model failures, there are learnings for other businesses.
What questions should be asked in the quest to identify Business Model Risk ?
There are at least five questions that can provide some insights into the robustness of the business model.
- How sound and sustainable is the underlying growth and profitability ?
- Does the business truly own a piece of the value chain or is it essentially just a trader ?
- Does the business need to continually engage in high or excessive risk taking to sustain itself and continue to grow ?
- Is your business at risk of becoming obsolete ?
- Is the business reliant on key agreements or a government concession to exist ?
The analysis is all about challenging how an organization or individual business generated its revenue and earnings. Then being assured that the business(es) can continue to do so in the future.
The above is not an exhaustive list of issues to consider when assessing Business Model Risk. The key activities are to critically assess the status quo and challenge the assumption that the business can continue to generate value the way it has in the past.