Economic Model Part 2: Why You Are Blind to Your Economic Model
December 9, 2011
This is the second in a series of posts that I am writing aimed at helping entrepreneurs maximize their economic performance. You can find a summary of the economic model series here. My first post defined economic models and described their importance for growing a business. This post explains why many people don’t understand the importance of economic models.
Why You Don’t Think About Your Economic Model (Enough)
Understanding and managing your economic model performance as part of your comprehensive management system is extremely important — but many managers, including financial managers, fail to optimize their economic results.
These days, there are few people who truly understand and capitalize on economic models. There are several reasons for this:
– Focus on users: In the consumer Internet markets, there is a current, somewhat singular, importance placed on looking at users, user engagement, and user growth in the Internet wave as fundamental metrics. Why worry about how you are going to make money when everyone seems to have this focus in mind?
– Focus on gross margins and revenue growth: In the B2B technology markets, there is a current, somewhat singular, importance place on gross margins and revenue growth as fundamental metrics. Why worry about your complete economic model if all you need to do is manage a portion of it?
– Lack of transfer of knowledge from the public companies: Many public companies purposely disguise their economic models, probably for two reasons. First, they don’t want their competitors to know when they have great economic models (why attract competition?). Second, they when they have poor economic models, they don’t want their shareholders and financial analysts to figure out how poor the management team is (or they have hope that the situation will change before they are discovered). Since the companies are inherently poor at describing their economic models, the internal focus that they have on it (when they have it) is not communicated to the smaller company managers, many of whom have not worked in larger companies. Believe me, the best large companies have an extreme focus on their economic models (particularly when the management owns a large chunk of the business)!
– Lack of exposure to Financial Analysts: Interesting enough, financial analysts (the people who cover public and larger private companies) understand economic models better than anyone else, as they need to build their own models to predict the performance of the companies they cover. Unfortunately, most of them don’t share their models, as they believe that they are proprietary and don’t want competing analysts to know their unique models. Therefore, publicly they discuss their final predictions for companies but they generally stay away from describing their models. Some of the larger private company managers and all of the public company managers have exposure to these analysts and, therefore, are pushed to think about their economic models a lot, but most smaller companies aren’t exposed to how important economic models are.
–Numbers are un-fun. Most entrepreneurs are busy trying to build their product, their team, and their customer base and don’t have enough time for the economics of your business. They think, “Isn’t that what they have a financial person for?”
– Lack of skill: Financial people are generally good at satisfying accounting and regulatory requirements and providing GAAP financial results, but GAAP financial results are very different than economic models and can be misleading, particularly in high-investment-for-growth companies. Most financial staff have NOT been trained in business economic modeling (although many think that they have been and would take offense at this statement).
– Lack of good operating metrics: Economic models need good operating metrics to be truly clear. It takes real work to gather and clean operating metrics so that they can be used in modeling.
– Lack of time: Economic models expressed on spreadsheets take real time to develop, test, and iterate on. If the CEO is not focused on it and setting it as a priority then it will not get done or not get done well.
– Lack of Understanding: I can’t count how many times I have been presented with economic models of businesses that don’t make any sense. They are definitely spreadsheets with projections, most with amazingly rosy projections, but they are either missing the key characteristics of the true economic model of the business, they lack calibration with reality, or they are overly complicated (and I have never had the patience to figure them out). In essence, managers may think that they have a good economic model understanding when they don’t.
There are probably a lot of additional reasons that you don’t focus on your economic model (enough). These are my guesses, but please comment if you think that there are important reasons that I am missing.
My next post: “Every Company Has an Optimal Economic Model Waiting to Be Discovered”
If you want to learn more about economic models, keep reading. I would also appreciate any comments or suggestions that you have, as I plan on turning this series into an e-book and I want to make sure that it is as clear and complete as possible.