If a company can transition from simply delivering a product to building a community, it can unlock extraordinary competitive advantages, thereby creating and sustaining a superior business model.
A startup’s business model -- like any company business model -- is comprised of four constituent parts: customer value proposition, technology and operations, go to market, and profit formula. Each of these parts is defined as follows:
The customer value proposition is a sustainably differentiated solution for an important unmet customer need.
The technology and operations model is the set of operational methods used by the startup to fulfill its value proposition.
Go to market is how potential customers are made aware of the startup’s offering.
Finally, the profit formula is the method in which the startup will make money and the embedded unit economics of its offering
The profit formula for a startup is typically calculated as the lifetime value of a customer (LTV) divided by the customer acquisition cost (CAC). LTV equals the discounted present value of the gross profit (not revenue, a mistake many make) earned over the life of a typical customer’s relationship.1
1 Eisenmann, Thomas. "Business Model Analysis for Entrepreneurs." Harvard Business School Background Note 812-096, December 2011.
Factor in a conservative churn rate (that is, the rate by which your customers’ attrit and no longer pay you), which caps your customer lifetime at three years
Assume a conservative discount rate of 30% to factor in the high cost of raising venture capital
Apply a conservative gross margin percentage, recognizing that a startup’s gross margin is suboptimal for many years
Many entrepreneurs are also overly optimistic about their CAC, particularly since customer acquisition is a bit like drilling oil. Sometimes you hit a gusher, and it flows beautifully. But eventually, that well runs dry, and you need to find another one. Similarly, you may come upon a particular customer acquisition tactic that works beautifully and with favorable economics. But, eventually, it runs its course, and you need to deploy another tactic. Thus, entrepreneurs should be careful not to extrapolate too readily from their initial, favorable CAC results with their first few gushers and their early customer cohorts.
Network effects are often discussed as a powerful attribute of a business model where the product or service becomes more valuable to any given user as more users are added. Chief is an excellent example of network effects: each high-powered female executive who joins Chief makes the Chief network that much more valuable to join. Another valuable business with strong network effects is Linkedin. Once you discovered that your professional network joined Linkedin, it was impossible not to become a member yourself. Thus, Linkedin’s strong network effects lower its customer acquisition costs (CAC), improving the LTV/CAC ratio.
When a business has network effects, it can generate virality in its customer acquisition engine: each new customer attracts other customers. The economic power of viral marketing is evident when you apply the degree of virality to your LTV/CAC math. For example, if each new customer attracts, on average, 0.5 additional new customers, then your LTV is 1.5x that of a company with no virality. For this reason, network effects are highly valued. Bill Gurley of Benchmark notes that network effects are one of the most important elements required for a company to become a member of the “10x Revenue” club (which should be renamed the 20x Revenue club in today’s stock market).
“Community effects,” as we define and experience them throughout our portfolio, represent a superset of network effects. That is, you can have network effects without building a community. But having a community can have a powerful, positive impact across all elements of the business model, driving even more value and supercharging your network effects. Specifically, a vibrant community can itself represent the core of the value proposition for the startup, as in the case of Chief. As a result, the stronger the community, the more compelling the value proposition.
Further, a strong community will result in enthusiastic members helping acquire new members, accelerating the go to market process resulting in lower customer acquisition costs, and a tighter viral loop. CAC thus decreases while LTV increases, as noted above, improving the startup’s profit formula.
Community members support one another. As described in the earlier chart from Jono Bacon’s book, People Powered, this peer-to-peer support results in a company being able to execute a lower cost of service as the burden of service is not solely on the backs of its employees. Lower cost of service translates to high gross margins, which results in an improved LTV. Also, members are reluctant to abandon the community, resulting in increased retention and thus lower churn. Churn represents the equivalent of being expelled from the community, something that loyal community members are loath to do. For example, Codecademy believes there is a dramatically lower churn rate for its 70,000 community members who are active on its Discourse forum on a monthly basis compared to the millions of learners who do not actively participate in its forum. That is because they know that community engagement is correlated with a 20% higher rate of product engagement (as measured by code submits). By achieving a lower churn rate, community companies see improved LTV as the cash flows associated with a customer persist over a longer lifetime. Thus, if achieved, community effects are network effects on steroids: as engagement grows, the community gets smarter, faster to respond, more globally available, and generates more value.