This post originally appeared on the 1871 blog here.
Does this sound familiar? “So tell me, how exactly does your business make money?” asks the inquisitive VC. “Um….what do you mean?” you ask, “Can’t you see our hockey stick growth projections on page 2?
Last month my post called “Looking Backward to Help Your Business Move Forward” highlighted why you should make time each year to look back and review things like where you spent your time and cash, as well as calculating how profitable your customers really are. These types of insights should serve as building blocks to your financial model, and can help your business move forward in the New Year.
But most of you entrepreneurs don’t take the time to really focus on the building blocks of their financial model. Instead, you make these three mistakes that cause the VC’s to scurry away in the opposite direction:
1. You pick some arbitrary percentage to grow revenue
To show your top-line revenue growth you create your fancy spreadsheet formula that says “=[Last Month’s Revenue] * (1 + 50%).” Drag that formula across 12 months to show that your current $1,000 per month of revenue will magically turn into almost $90,000 per month by the end of the year (and over $11 million per month by end of year two).
As Ace Ventura, Pet Detective said, “Fiction can be fun!”
What you really need to show are the building blocks behind that total revenue number and how you can realistically achieve those numbers. Assuming very simply that you only sell one service option at the same price for everyone, then your revenue should at the very least be calculated based upon the number of customers multiplied by that price. That’s a start…
But let’s take this simple scenario even further. How do you reach those customers so they purchase your service? Is there a general sales cycle with your customers? Most likely they follow some sort of cycle that is similar to: Lead à Prospect à Qualified à Purchase. How do you get a Lead? What is your conversion percentage for each step in your sales cycle? (E.g. 25% of Leads become Prospects.) How long does each step in the cycle take? (E.g. it takes an average of one week for a Prospect to become Qualified.)
Now you can make your model more interesting and based in reality. For instance, assuming you advertise on Google, then your model would now show how many Google ad clicks you’d need to achieve each Lead, and how long until some of those Leads would become paying customers. In this process, you’re showing how the controllable action of running ads correlates directly to your revenue model based upon a derived customer acquisition cost (CAC) – more on that later.
Modeling with these details lets you form an action plan that links your daily actions, such as advertising, to your monthly and annual financial goals. This is much better than just picking an arbitrary percentage increase.
2. You don’t distinguish between fixed and variable costs
Similarly to your revenue forecast, you shouldn’t choose an arbitrary percentage to grow your total expenses either. That’s because some of your expenses are fixed and some are variable.
Your fixed expenses are things like your website development costs, founder salaries (if you can pay them!), rent, and other things that you pay whether you have zero customers or 100 customers.
In contrast, your variable expenses vary depending on your revenue projections and should be consistent with the same numbers you’re using to project revenue. Continuing with our prior example, the Google advertising spend is clearly dependent on how many ad clicks you expect. So if you’re projecting 1,000 ad clicks to support your revenue in Month 1, then you should also project your advertising spend at 1,000 times the cost per click (CPC) of those ads. Other examples of variable costs are customer support, web hosting, and beer for employees (we need happy hours right?!)
3. You don’t give any “what-if” scenarios
Finally, it would be naïve to think the VC will accept your financial model and agree with your assumptions from the start. To proactively address this, you should provide at least four versions of your financial model to the VC: 1) your base case, 2) 50% less revenue, 3) 50% more revenue, and 4) oops, ZERO revenue.
These “what-if” scenarios let you show the VC how you’d manage risk if revenues come in lower than expected, and also shows the VC how profitable your business can be if you achieve a great product/market fit. The zero revenue version is your worst case scenario and shows how much runway you have with your existing cash.
Now, just because you’ve identified the key building blocks to your business’s financial model doesn’t mean you’ll actually achieve those targets. The key here is that you at least have a plan in place for how you could in theory achieve your targets. By having this plan, the VC you’re meeting with will have a clearer picture of “how your business makes money.” The VC may still disagree with the model and its assumptions, but at least you’ve laid them out for discussion; the VC can no longer argue that you don’t understand your business’s financial model.
In my post next month I’ll dig a bit deeper on the customer acquisition cost calculation briefly mentioned in problem #1 above, and its associated payback period; and I’ll show how those things correlate directly to how much equity you keep in your company as you grow.
</my two cents> Have a Happy New Year!