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Whether you’re launching a small business, studying business in school, or are simply curious about how companies make money, understanding what a business model is and how it works is a good place to start.
A business model is essentially a company’s game plan for making money. It includes what a company sells, how it builds or sources its products or services, whom it sells to, and how it will turn a profit. Below, we’ll dive deeper into this business model definition, explore some of the most common types of business models, and look at how to choose the right business model for your next big idea.
Key Points
• A business model describes how a company creates and delivers value to its customers and makes money in the process.
• There are many types of business models, including direct sales, subscriptions, and franchises.
• Defining a business model is crucial to a company’s success, but so is refining that model over time.
• Many companies operate with more than one business model, especially if they have different products and/or services for different customer segments.
Business Model Definition
A business model is a framework that describes a company’s central strategy for making money. Ultimately, a business model should address the problem that your company solves for customers (including who the customer is and the products and services you offer to them), how you’ll deliver that solution, and how you’ll make money doing so — meaning how the customers will pay and how your business’s revenue will cover your expenses and generate a profit. In other words, a business model includes how you create value, how you deliver that value, and how you capture it as revenue.
A business model isn’t a set-it-and-forget strategy. As customer needs, technology, and competition change, businesses often adjust their models over time.
For instance, you might open a neighborhood bakery. Your business model might involve selling fresh bread and baked goods directly to local customers through your storefront. Revenue comes from individual sales while expenses include ingredients, rent, labor, and equipment. But you might evolve that business model over time by offering monthly bread baskets (a subscription product) or selling your products to local grocery stores and restaurants (wholesale distribution).
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Key Components of a Business Model
If the business model definition still feels a little abstract, here are the key components that can help you better understand what a business model actually involves.
• Value proposition: A value proposition details why customers should choose your products and services instead of those of your competitors. You’ll also need to identify how you’ll create, produce, or source those products and services.
• Target market: This explains who and where your customers are, including their demographics, interests, and needs. You also have to plan for how you’ll reach them (marketing and advertising).
• Revenue streams and cost structure: Perhaps most importantly, you need to identify how your business earns money and what expenses it must cover while still remaining profitable and meeting its business goals.
• Distribution channels: Your business needs to explain how you’ll actually deliver your products or services to customers, whether it’s selling through a website or mobile app (e-commerce), retail store, wholesaler, or sales team.
How a Business Model Works
At its core, a business model is about developing a blueprint for how your company creates value, delivers products or services to customers, and generates revenue. Ideally, that model should allow you to earn enough revenue to cover costs and generate a profit.
For your business to work, you need to:
• Identify a product or service that you can create and deliver.
• Make sure that it addresses a pain point or desire of your customers and that customers will be willing to pay for your solution so that you’ll have a profitable business.
• Determine how you’ll market and deliver that product or service.
• Create a system for customers to pay for that product or service.
• Develop a plan to manage costs and maintain profitability as your company grows.
Some companies may have a straightforward business model. Again, imagine that bakery. You might simply bake bread and pastries; that’s a product that has wide appeal. After all, we’ve all got to eat! You’ll bake the bread and pastries in-house with the proper equipment (you might need a startup loan to get the bakery going) and, potentially, employees.
You might market your bakery through social media, advertising, local partnerships, and word of mouth. Customers come into your bakery and purchase your products directly, earning you revenue from every sale. You’ll just need to price those loaves and pastries high enough to cover all your expenses and still walk away with money at the end of each month.
But companies often have much more complex business models and may even use multiple business models at once. Amazon, for example, sells products directly to consumers, operates a marketplace for third-party sellers, offers subscription services through Amazon Prime, and generates advertising revenue from sponsored product listings. And that’s just the business-to-consumer (B2C) side of things; Amazon also has a significant business-to-business (B2B) offering, including services and products designed for other businesses.
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Types of Business Models
There’s no one best business model. In fact, there are several core types of business models that could make sense for your company. Let’s look more closely at a few popular models.
Subscription Model
With a subscription model, customers pay a recurring fee, often monthly or annually, for ongoing access to a product. This could be a streaming service, magazine, clothing or makeup club (curated subscription boxes), or software.
If you receive any items on autoship (like having dog food delivered to your home once a month), that process operates much like a subscription model. You might also have a subscription (i.e., membership) to a location, such as a gym or a store like Costco.
Freemium Model
The freemium model offers a basic version of a product or service at no cost while charging for premium features or additional functionality. The goal is to introduce your customers to the free version but provide enough new value with a paid version that they’re willing to upgrade.
Many apps and software programs use this model. For instance, a free plan might include limited service or fewer customization options. That might work for a customer at first, but over time, when the customer is finding true value in the program, they might be willing to pay more for additional features.
Marketplace Model
The marketplace business model connects buyers and sellers through a shared platform. These companies often don’t sell their own products or services but instead provide the space where those customers connect in order to make money — often through commissions, transaction fees, or listing fees.
Think about Airbnb: Hosts provide accommodations, while guests use the platform to find and book stays. Airbnb earns money through service fees charged on bookings.
Direct Sales Model
In a direct sales model, companies sell their products or services directly to consumers instead of relying on third-party retailers or distributors. Businesses may sell through their own websites, company-owned stores, catalogs, or sales representatives. This gives the companies more control over pricing, branding, customer relationships, and the overall buying experience.
Advertising Model
Some companies generate significant revenue by selling advertising space or access to their audience. News websites, search engines, pod may all rely heavily on ad revenue, but some may have additional sources of revenue.
A newspaper is a traditional example of an advertising-supported business. It may earn revenue from businesses that purchase ads while also charging readers via subscriptions or individual sales.
Franchise Model
A franchise model lets the business owner (franchisor) license its brand, business system, and operating processes to independent business owners (franchisees). Rather than building every new location themselves, franchisors expand by allowing franchisees to operate under an established brand — and, of course, pay their franchisor various franchise fees and ongoing payments.
Fast food restaurants are a great example of franchise models, but fitness centers and hotels also commonly use franchising.
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Business Model Examples
As we saw above, many businesses have multiple ways of reaching and selling to customers and they might even design different products and services for completely different groups of customers.
The list below shows some real-world business model examples of different types. Just remember that the sample companies listed may use more than one approach.
• Subscription model examples: Netflix, Spotify, and BarkBox
• Freemium model examples: Zoom, Google Drive, and Canva
• Marketplace model examples: Airbnb, Etsy, and Amazon
• Direct sales model examples: Tesla, Pampered Chef, and Casper
• Advertising model examples: BuzzFeed, Forbes, and Dictionary.com
• Franchise model examples: McDonald’s, Ace Hardware, and Massage Envy
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How to Choose the Right Business Model
Your business model should fit your company’s products, customers, and goals. Here’s what to ask yourself as you develop your business model.
• What products or services will I offer?
• How will I create or source those products or services?
• What problem do these products or services solve and for whom?
• How will I reach and communicate with these customers?
• How will I sell to these customers?
• How will I stand out from competitors?
• What are my costs, and how do I price these products and services to turn a profit?
Going back to the bakery example, your answers might look like the ones below.
• What products or services will I offer? Bread, baked goods, coffee, and other treats
• How will I create or source those products or services? Bake in-house using financed equipment
• What problem do these products or services solve and for whom? People looking for quick and easy everyday food for a commute, a treat, or a convenient meal option
• How will I reach and communicate with these customers? Social media ads and posts, signs in the neighborhood, and word of mouth
• How will I sell to these customers? Direct sales at first, but potentially subscription and/or wholesale down the road
• How will I stand out from competitors? Secret recipe, more convenient location and hours, and memorable customer service
• What are my costs, and how do I price these products and services to turn a profit? Small business loan payments, rent, employee wages, ingredients, and equipment; a 400% markup above ingredient costs will typically allow market-rate prices and create sufficient revenue
The Takeaway
Defining and maintaining a business model is critical to running a successful company. A business model defines the value you bring to the market, who your customers are, how you’ll sell to them, how they’ll pay for your products and services, and how you’ll manage costs so that you can turn a profit.
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FAQ
What is the most common type of business model?
There isn’t one standard business model that’s used by all companies. However, some of the most common models include direct sales, subscription, advertising, marketplace, and franchise models. A business’s approach often depends on the industry it’s in. For instance, software companies frequently use subscriptions, while many consumer goods companies rely on retail or direct sales.
What is the difference between a business model and a business plan?
A business model explains how a company creates value and generates revenue. It focuses on the basic structure of the business, including customers, products or services, costs, and income sources. A business plan is a more detailed strategy, concentrating on how the company will operate. It may include market research, financial projections, marketing strategies, goals, and plans for growth.
Can a business have more than one business model?
Yes, many companies operate multiple business models simultaneously, especially as they grow and diversify. For example, Amazon runs an e-commerce marketplace, a subscription service (Prime), a cloud computing business (AWS), and an advertising business. This is common when a business serves different customer segments, sells through different channels, or wants to diversify revenue streams and reduce reliance on a single source of income.
What makes a business model successful?
A successful business model identifies a real customer problem and provides true value that customers are willing to pay for to solve that problem. That means a business model must include a valuable product and a true understanding of the customer — including what they’ll pay and how they’ll find you.
How do business models relate to revenue streams?
A business model explains the overall way a company operates, while the revenue streams are the specific ways a company earns money. A solid revenue stream is part of a successful business model, which also includes details about the company’s products and services, customers, and costs.
Photo credit: iStock/VioletaStoimenova
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