Understanding How Entrepreneurs Make Money

You’ve done all your hard work and planning, secured funding and established your business. But what about the rewards? Where, when and how can you expect your high-yield rewards to be realized, and why should your entrepreneurial venture succeed where others have failed?

Imagine two hypothetical workers. Peter goes to the office each day, works a standard 40-hour workweek and gets paid a standard salary. He is great at his job, but his contributions to the world remain confined to his work.

Paul has a passion to change and improve the world by introducing new products and services. He works many more than 40 hours a week, investing his time, capital and energy to try something new that he hopes will make the world a better place.

Clearly, the world would be less dynamic if there were only Peters and no Pauls around. Paul takes more risks and puts in more effort than Peter, so it seems logical Paul will have a greater impact on the general welfare through his contributions. If the reward for Paul is more or less similar to that of Peter, however, Paul will not be as willing to put in the extra effort to improve the world's wellbeing. (For related reading, see: The Real Risks of Entrepreneurship.)

According to neoclassical economic theory, a lack of suitable rewards discourages entrepreneurs to take on risk and put in extra effort, without which the world becomes stagnant. Government authorities rightly offer entrepreneurs special rewards through patents, copyrights and royalties. Entrepreneurs are less likely to invest their time, effort, energy and money without windfall profits.

Entrepreneurs introduce new products or services that may result in significant improvements in productivity, reduction in costs and improvement in quality of life. Knowing their offerings much better than anyone else and being aware of customer needs, the entrepreneur can charge a premium for their innovations, which translates to big rewards.

If competitors are not able to build and introduce similar products or services in a short span of time, the product becomes a monopoly for the entrepreneur, and he or she can expect windfall profits from being the sole manufacturer or sole service provider. (For related reading, see: How Monopoly Anti-Trust Laws Affect Consumers.)

Even if competitors find it easy to replicate and introduce similar products quickly, the entrepreneur can seek protection for their innovation through patents or copyrights. These channels offer protection to the original inventor and act as a safeguard for successful entrepreneurial ventures.

But how long can this monopoly continue? Without government intervention in the form of patents or copyright protection, profitability will continue until competitors start offering similar products and services. Without any intervention the market becomes open to further innovations and new variants on the original product or service. Entrepreneurs usually keep a close eye on such developments and are circumspect enough to upgrade their products and maintain the upper hand in the market.

In the case of patents, protection is available for a certain amount of time, which can span a few months to a few years. (In the United States, patents usually last for 20 years.) This again encourages healthy competition: either entrepreneurs start work on something new or they succumb to market Darwinism.

When it comes to money matters, timing is very important. Here is an illustrative graph indicating all possible cash flows and their timing during the different phases of an entrepreneurial venture:

Term 1 to Term 4 (Pain Period) – This is the initial investment period, where different activities will be performed including, but not limited to, product idea development, feasibility and market study, prototype building, and customer identification. The order may differ depending on the venture, but the concepts remain the same. It is assumed that funding from angel investors becomes available in Term 4.

Term 5 to Term 6 (Introduction Period) – Activities in this period may include applying for and securing patents and building sales channels and a distribution model to final product introduction to the market.

Term 7 to Term 9 (Profit Period) – These terms are the profit-taking “monopoly” periods when the entrepreneur is either protected by patents or copyright, or there are no competitors for other reasons.

Term 9 is assumed to be the peak profit period, just prior to competitors entering the market. It is during this term that further development is initiated for introducing new product variants. However, reinvestment and research and development can come earlier, depending on the product's lifecycle and other factors. This can also be the time to introduce the original offering to new markets.

Term 10 to Term 11 (Sunset Period) – At this point, entrepreneurs may exit the venture completely by closing it completely or selling it to interested parties, or they may continue with newly developed variants. Profits will vary greatly during these terms. (For related reading, see: Top Exit Strategy Tips for Small Businesses.)

The above is an illustration of a general entrepreneurial cycle. The duration and activities mentioned will vary depending on the nature of the product and markets. For example, a pharmaceutical drug may have a longer monopoly period because of a patent, while a mobile technology innovation may get replicated within a very short span of time.

All business ventures aim for profitability. Owing to the high risk/high reward scenarios of entrepreneurial ventures, entrepreneurs are expected to make windfall profits, provided they plan their activities carefully and complete their due diligence.

(For related reading, see: Entrepreneurship Is Declining: How to Turn it Around.)