` Building a Business Model Presented by: Dr. Ajay Agrawal, Peter Munk Professor of Entrepreneurship, The Rotman School of Management 19, December 2007

The Entrepreneur’s Three Key Questions December 19, 2007 Entrepreneurship 101 @ MaRS Professor Ajay Agrawal Rotman School of Management ©2007 Ajay Agrawal

Three Key Questions What’s my business? What’s my business model? What’s my pricing strategy? ©2007 Ajay Agrawal

What’s my business?

What’s my business model?

What’s my pricing strategy?

What’s my business? ©2007 Ajay Agrawal

What’s my business? Analytical approach to identifying the choice set Market size Competition Barriers to entry Social relationships Industry knowledge Costs of switching businesses Technical, analytical, marketing, social Suggested reading: Scott Shane (2000) “Prior Knowledge and the Discovery of Entrepreneurial Opportunities,” Organization Science Ed Roberts (1991) “Entrepreneurs in High Technology,” Oxford University Press ©2007 Ajay Agrawal

Analytical approach to identifying the choice set

Market size

Competition

Barriers to entry

Social relationships

Industry knowledge

Costs of switching businesses

Technical, analytical, marketing, social

Suggested reading:

Scott Shane (2000) “Prior Knowledge and the Discovery of Entrepreneurial Opportunities,” Organization Science

Ed Roberts (1991) “Entrepreneurs in High Technology,” Oxford University Press

What’s my business model? ©2007 Ajay Agrawal

What’s my business model? Most common options Sell service License technology Sell product Key issues Who owns key complementary assets? (market power?) Appropriability of value? Enforcement of patent protection? Suggested reading: David Teece (1986) “Profiting from Technological Innovation,” Research Policy Ed Roberts (2003) “The Product Market and the Market for ‘Ideas’: Commercialization Strategies for Technological Entrepreneurs,” Research Policy ©2007 Ajay Agrawal

Most common options

Sell service

License technology

Sell product

Key issues

Who owns key complementary assets? (market power?)

Appropriability of value? Enforcement of patent protection?

Suggested reading:

David Teece (1986) “Profiting from Technological Innovation,” Research Policy

Ed Roberts (2003) “The Product Market and the Market for ‘Ideas’: Commercialization Strategies for Technological Entrepreneurs,” Research Policy

Cooperate or Compete? Gans and Stern evaluate the commercialization strategy for start-ups: Cooperate (sell license) commercialize by engaging in an intermediate market to sell their intellectual property to an incumbent Compete (sell product) commercialize by developing the good in-house and competing directly in the product market The decision of whether to license is based primarily on two factors the excludability environment the specialized complementary asset environment ©2007 Ajay Agrawal

Gans and Stern evaluate the commercialization strategy for start-ups:

Cooperate (sell license)

commercialize by engaging in an intermediate market to sell their intellectual property to an incumbent

Compete (sell product)

commercialize by developing the good in-house and competing directly in the product market

The decision of whether to license is based primarily on two factors

the excludability environment

the specialized complementary asset environment

Two Elements of the Commercialization Environment The excludability environment To what extent can successful technological innovation by the start-up preclude effective development by an incumbent with knowledge of the innovation? The specialized complementary asset environment To what extent does the incumbent’s complementary assets contribute to the value proposition of the new technology? ©2007 Ajay Agrawal

The excludability environment

To what extent can successful technological innovation by the start-up preclude effective development by an incumbent with knowledge of the innovation?

The specialized complementary asset environment

To what extent does the incumbent’s complementary assets contribute to the value proposition of the new technology?

Benefits from Engaging the Intermediate Market for R&D Savings If the incumbent firm has already invested in developing the specialized complementary assets, the entrant can save the costs of duplicating this effort and the savings may be shared between the incumbent and entrant Less competition If the entrant engages the intermediate market with its invention, that will preclude it from entering the product market. As such, there will be less competition in the product market and so producers will collect a greater surplus ©2007 Ajay Agrawal

Savings

If the incumbent firm has already invested in developing the specialized complementary assets, the entrant can save the costs of duplicating this effort and the savings may be shared between the incumbent and entrant

Less competition

If the entrant engages the intermediate market with its invention, that will preclude it from entering the product market. As such, there will be less competition in the product market and so producers will collect a greater surplus

Costs of Engaging the Intermediate Market for R&D The main cost is the potential expropriation of intellectual property secrets and know-how by trading partners arising from the paradox of disclosure ©2007 Ajay Agrawal

The main cost is the potential expropriation of intellectual property secrets and know-how by trading partners arising from the paradox of disclosure

Importance of Complementary Assets Excludability Low Low High High ©2007 Ajay Agrawal Compete (stealth strategy, Christensen, disk drives; disrupts existing industry leadership) Cooperate? (strategy: invest in reputation for trading in ideas; e.g., Cisco; formal organizations, e.g., ASCAP in music, TLOs in universities, VCs; reinforces existing industry leadership) Either Strategy (strategy: entrepreneur’s choice, relative returns from competition v. cooperation?; e.g., Xerox developed complete vertical chain versus Nintendo’s widespread licensing of software development tools) Cooperate (strategy: demonstrate value, attract multiple bidders; biotech/pharma; reinforces existing industry leadership)

What’s my pricing strategy? ©2007 Ajay Agrawal

What’s my pricing strategy? Cost-plus VS Value-added Variation in demand creates need for pricing Examples Price discrimination Bundling Suggested reading Carl Shapiro and Hal Varian (1999) “Information Rules,” Harvard Business School Press Timothy Aeppel (2007) “Changing the Formula: Seeking Perfect Prices, CEO Tears Up the Rules,” Wall Street Journal ©2007 Ajay Agrawal

Cost-plus VS Value-added

Variation in demand creates need for pricing

Examples

Price discrimination

Bundling

Suggested reading

Carl Shapiro and Hal Varian (1999) “Information Rules,” Harvard Business School Press

Timothy Aeppel (2007) “Changing the Formula: Seeking Perfect Prices, CEO Tears Up the Rules,” Wall Street Journal

Which Price is Right? Estimated Costs: Parts ($400), Labor ($100) What should the selling price be? ©2007 Ajay Agrawal

Estimated Costs:

Parts ($400), Labor ($100)

What should the selling price be?

Extension: Demand Curve What is the optimal price? Profit? ©2007 Ajay Agrawal

Simple Example (1) Product: X Customers:A, B WTP A,B (X): $50 P = Π = ©2007 Ajay Agrawal

Product: X

Customers:A, B

WTP A,B (X): $50

P =

Π =

Simple Example (2) (Introduce variance in WTP) Product: X Customers: A, B WTP A (X): $50 WTP B (X): $20 P = Π = ©2007 Ajay Agrawal

Product: X

Customers: A, B

WTP A (X): $50

WTP B (X): $20

P =

Π =

Simple Example (3) (Variance in WTP) Product: X Customers:A, B WTP A (X): $30 WTP B (X): $20 P = Π = ©2007 Ajay Agrawal

Product: X

Customers:A, B

WTP A (X): $30

WTP B (X): $20

P =

Π =

Simple Example (4) (Introduce Price Discrimination) Product: X Customers:A, B WTP A (X): $50 WTP B (X): $20 P A = P B = Π = ©2007 Ajay Agrawal

Product: X

Customers:A, B

WTP A (X): $50

WTP B (X): $20

P A =

P B =

Π =

Extension: Demand Curve What is the optimal price? Profit? ©2007 Ajay Agrawal

Optimal (Single) Price (Profit = 225) ©2007 Ajay Agrawal

Profit Increase by Price Discrim. (Profit = 300) ©2007 Ajay Agrawal

Simple Example (5) Product: X, Y Customers: A, B WTP A (X): $50, WTP A (Y): $20 WTP B (X): $20, WTP B (Y): $50 P X = P Y = Π = ©2007 Ajay Agrawal

Product: X, Y

Customers: A, B

WTP A (X): $50, WTP A (Y): $20

WTP B (X): $20, WTP B (Y): $50

P X =

P Y =

Π =

Simple Example (6) (Introduce Bundling) Product: X, Y Customers:A, B WTP A (X): $50, WTP A (Y): $20 WTP B (X): $20, WTP B (Y): $50 P X = P Y = P X,Y = Π = ©2007 Ajay Agrawal

Product: X, Y

Customers:A, B

WTP A (X): $50, WTP A (Y): $20

WTP B (X): $20, WTP B (Y): $50

P X =

P Y =

P X,Y =

Π =

End ©2007 Ajay Agrawal