One of the top reasons companies fail is that they run out of money. That seems easy to avoid, right? Oddly enough, many entrepreneurs do not have clarity around their revenue sources and even fewer have a strong grasp of their operational costs.
How can so many brilliant and tenacious entrepreneurs fail to get a clear picture of their business operations? Unfortunately, most entrepreneurs dread building financial models, as the process is rarely laid out in an easy-to-follow format. I want to change that. I believe that all entrepreneurs can quickly and easily get a handle on their financial operations.
Let’s take a look at the construction of an easy-to-follow financial model.
Traditional financial statements include the income statement, the balance sheet, and the statement of cash flow. We’re going to focus on the most critical aspect – the income statement.
The income statement is important, as it will allow you to develop and analyze your revenues and expenses. This is the thrust of what we want to understand as business owners. How much revenue flows through and how much does it cost?
Revenue – everything that comes in through sales
Cost of Revenue – all expenses associated with each revenue stream
Gross Revenue = Revenue – Cost of Revenue
Research and Development (R&D) – all expenses associated with developing your product or service.
Sales, General, and Administrative (SG&A) – all expenses associated with maintaining, promoting, and selling your product or service.
Operating Revenue = Gross Revenue – R&D and SG&A
Interest Expense – interest paid
Tax – generally 30% of taxable income
Net Income = (Operating Revenue – Interest Expense) x Tax
If you have $100 in revenue and $30 in cost of revenue, you would have $70 in gross revenue or 70% gross margins. If you spent $10 on R&D and $30 on SG&A, you would have $30 in operating revenue or 30% operating margins. If you paid $5 in interest, you would have $25 in taxable income. Uncle Sam would take $7.5 and you would have $17.5 in net income of 17.5% net margins
You keep $17.5 from every $100 you make. This is a healthy company.
If your net margins are negative for a long period of time, you want to reassess your operations. The average company should attempt to break even by year two and achieve net margins greater than 10%. Of course, there are certain companies that fall outside of this range. Typically, companies that derive their revenue from ads take three times longer to reach profitability.
The one item that you should always include from the balance sheet is cash. View the amount of cash that comes into the company each month, against the amount of cash it takes to run the company each month. This will give you a clear picture of your operations.
If you have questions about building financial models, feel free to leave a comment.
I recently created a workbook and spreadsheet tutorial titled, Master the Finance Game: A Guide to Building Financial Models, Valuing Companies, and Raising the Right Type of Capital, to teach entrepreneurs how to create a streamlined version of the traditional financial model. You can read more about it at www.atelieradvisors.com/growth
In my past six years of advising early-stage companies, I have come across a myriad of founders who fear the F word. Finance should not be feared.
Understanding finance empowers you to build your company, motivate your team, attract customers and secure capital. So let’s dive in!
The most critical aspect of financial statements is the income statement. Understanding your balance sheet and statement of cash flow is helpful, but we are going to focus on what is critical — how will you make money, how much will it cost you and how will you track it?
Get Rid of the Box
The presentation illustrates four basic revenue models. You are not confined to these structures. Your job is to research your target audience and determine the best way to deliver your product or service to them and at what price. Five years ago, nobody was renting their car by the hour. Don’t be afraid to rethink existing revenue models. The pricing mechanics of your product or service are determined by what the current market will bear.
1) Get the Facts
We want to know what we are getting into before we start. Do you think you can build a company similar to Facebook? It should be easy to get people to sign up for a free profile and post interesting content. Actually, take a look at the amount of capital that is required to build a company that derives revenue from advertisers.
As you see in the presentation, it took about six years and $280 million for Facebook to reach profitability. This revenue model requires extensive resources and time.
Maybe you decide you will just build an app. That should be easy, right? Yes it is easy to build, but how will you monetize it? Poshmark, an innovative fashion resale company, was able to solve a huge problem at a price point that was substantially less than the alternative (consignment stores). They brought the experience in-house by creating in-app shopping parties, which yield 40% of their sales, and allows them to better control the user experience. To make the experience even more enticing, they handle all shipping materials and fees.
As you see in the presentation, if we assume that merchandise is sold at 50% of the initial value, this model could potentially yield approximately $7,475,000 in 12 months. This model has required $3.5 million thus far. Perhaps this model is more aligned with your appetite for risk.
If you want to sell merchandise online, you can do so as an e-tailer or as a marketplace. Unlike Poshmark, which is a marketplace as they do not purchase and hold inventory, Fab curates hard-to-find inventory. The Fab model requires more capital, but if done well can be a great site.
So by now, we see the broad continuum we are working with. Doing just a bit of research can really help us refine our financial strategy and increase our chances of success.
Keep in mind, if you take venture capital dollars you should be prepared to sell your company or file for a public offering. If that is not what you had in mind, determine a financial strategy that you can sustain on your own. More on this later.
2) Stay Alive
Most companies fail because they run out of money. Pretty simple, right? Actually, you would be surprised by the number of companies that build, but don’t budget, for growth. You have heard it before, “We don’t need a business plan.” You may not need a business plan, but I believe you need to build a business model and that business model should include a well-researched financial strategy.
Many people believe that they will “go viral.” That’s a commendable goal but how much does that cost? Perhaps you are Munchery and you send out invites that offer a free meal plus a bonus meal if you get 15 friends to sign up. I believe this is a brilliant strategy as everyone loves free food. But keep in mind, there is a cost associated with delivering this perk.
Your product or service may not have the ability to deliver a delicious meal, so how will you entice your target audience to get on board and share with their network? Make sure you have estimated this cost in your budget before you utilize this strategy. It is critical that you know how much you will give away to get the actual sale. You can give away $5 bills all day. At some point, you need to make money.
You must understand what motivates your target audience. Why do they need your product or service?
Customer acquisition cost is only one component. Make sure you understand other costs associated with running your type of company. Search www.sec.gov to review historical financials of similar companies. You can also pull together estimates via company interviews, blogs and other resources.
You do not need to spend a lot of money to gather data for your revenue and expense assumptions.
3) Keep Your Mind on Your Money and Your Money on Your Mind
Your goal is to acquire, engage and retain. Similar to our revenue model example, there are numerous ways to measure your company’s performance. Develop a system that works for your specific revenue model.
If you have a user-based model, you will want to understand how many users are coming through each campaign, how often they are engaging and how long they stay. It is one thing to get the user via a free account, but you should be as focused on getting them to visit often and engage for life. Facebook and Twitter have high engagement rates, with more than 50% of users logging in daily and spending 700 minutes or more per month.
Facebook and Twitter have high engagement numbers because they provide critical news and information to the user. Does your service invoke users to provide important content that is timely?
If you are building an app, you will want to understand the relationship users have with your app. If you monetize via in-app purchases or advertising, measure to ensure that your monetization rate is consistent with your industry. The average in-app purchase is $14 and over 70% of apps monetize via in-app purchases, as opposed to advertising. It is critical that your app motivate the user to further spend as advertising revenue is growing, but is not currently as lucrative.
Games are notorious for strong in-app purchases as players tend to bond with the competitive nature of the game. Is your app delivering a compelling experience that motivates users to continue usage?
If you have a subscription-based model, you want to understand how many users sign up beyond their 30-day trial or convert from the free account. As the free trial ends, reach out to understand why they didn’t make the transition to a paying customer. Is the monthly rate too high? Would they be interested if your offering had more robust features? Some of your free users may never convert, but it is important to communicate your value proposition on a regular basis as your users’ needs will change over time. LinkedIn has done a great job of continuing to increase premium services and communicating their value to users.
Services that deliver tangible value (save time, save money, increase health, increase wealth) have a stronger retention rate with users. Is your product or service enhancing the user’s life in a measurable way?
What’s it All Worth
Another important data point is valuation. By quickly estimating the value of your company, you can assess whether there will be interest from the venture capital community. Always use industry data to determine your company’s valuation range. Find the revenue multiple (transaction value or valuation / revenue) and apply it to your company. Do not rely on public comparables (they are too few) and discounted cash flow (you may not have positive cash flow) to determine valuation.
Not All Money is Equal
Develop a plan specific to your company’s goals. This includes your funding strategy. If you do not plan to sell your company in five years or file for an IPO in ten years, you should not pursue venture capital. There are other routes, such as loans or crowd funding.
If you have questions, feel free to reach us at info@atelieradvisors.com or comment below.
Delivering a compelling pitch is Step 0 in building your company. Whether you are pitching to a customer, an investor or a potential hire, you need to sell your vision with clarity, passion, and conviction.
Listed below are the 11 slides you must have when pitching to an investor:
OVERVIEW
Explain what you do. Your “Elevator Pitch” should be succinct and powerful. This is where you get their attention or lose it.
PROBLEM/OPPORTUNITY
Explain the problem you solve. Hopefully your product or service is a pain killer, not a vitamin. List statistics that support the opportunity.
SOLUTION
Explain how you are going to solve the problem in a unique and defensible way. How is your solution better? What is your unfair advantage?
TEAM
Describe why your team is qualified. What have they done in the past that makes them credible? Remember: investors invest in people, not companies.
MARKET
How big is your addressable market? Don’t make the mistake of listing a widely published industry statistic as your addressable market. Conduct a bottom up analysis of you market. If you sell software to health clubs, list how many health clubs exist. List the dollar value that it represents.
SALES, MARKETING + DISTRIBUTION
How do you plan to get money out of your customer’s pocket? Explain your sales process. Investors want to know that you have, at the very least, thought through the process. List results for past marketing campaigns and committed distribution partners.
COMPETITIVE LANDSCAPE
List your competitors. Explain why you are better. Never list that you do not have competition. If you product or service is a novel idea, you will want to list alternatives to your offering. If you are building the first personal, commuter helicopter that fits in a garage, your competition would be cars and other commuter airplanes.
FINANCE
Remember: investors are investing for a return. You need to convince them that you are going to make money and deliver a healthy return. Show your assumptions. Make sure they are well researched and believable. A bottom up analysis will deliver a clear picture of your prospects and aid you in building your company.
PRESS/TESTIMONIAL
What are others saying about you? Ask your customers to provide quotes on how well they like your product or service. If you don’t have customers, ask experts to weigh in on your idea.
CUSTOMERS
List paying customers and those that are in the pipeline. Show that you have identified future prospects and explain how you are taking steps to win their business.
STATUS
How much capital do you need? How will you use it? This is where a well-detailed financial model will help you be clear in your goals. Don’t forget to add a small amount for reserves.
A few tips for getting people to believe in your idea:
Connect Research your audience and relate to their interests.
Use images. A picture is worth a thousand words.
Research. Know your industry inside and out.
Be likable. Smile. Make eye contact.
Practice, practice, practice
You should know your story so well that you do not need to look at your slides. When raising capital, you never know when you will meet a prospective investor. So always be ready.
I heard an interesting statistic at the Decoded Fashion event in NYC last month — 95% of high fashion purchases are done in brick and mortar stores. This bit of knowledge may lead brands to believe that they should shutter online stores and focus on a brick and mortar only strategy. Think again.
Betsey Johnson built her first brick and mortar store in 1978 and expanded her empire by approximately two stores per year. Currently, she is closing 95% of her stores. Oddly, despite a 20% decrease in store sales and a 50% increase in wholesale sales, the company was planning to grow stores from 63 to 100 in the near future. Not surprisingly, the question most brands are asking is: what percentage of distribution should be devoted to traditional brick and mortar stores?
Bricks or Clicks?
Well known e-tailers are realizing the power of the physical store. Bonobos recently announced their launch into Nordstroms. Warby Parker credited their move into physical space for not only an increase in sales, but an increase in consumer insight and employee knowledge. After Gap acquired e-tailer Athleta and built physical stores, Tony Lenk, President of Gap’s E-commerce business, stated; “For every dollar that customers in the region spent over the Web, they shelled out an additional $4 in the store.” It is no surprise, consumers purchase more when they can touch and feel the merchandise. Clicks need bricks.
Balancing Act
As with any business decision, your bricks vs clicks ratio is derived from a blend of analytics and customer feedback. The question you want to answer is: where are consumers finding you? Strong brands, such as Bonobos, Warby Parker and Athleta, have the advantage of experimenting with brick and mortar by utilizing partnerships, pop up shops and acquisitions. Lesser known brands will have to be careful when they enter physical space on their own. A store build out can range from $100k to $500k, and comes with annual expenses that are difficult to unravel. A conservative ‘brick approach’ is one store per year, measured regularly against the metrics of other distribution channels.
Some brands do well in the digital world, while other brands require a high touch experience. I highly doubt Lululemon could have built a multibillion dollar wellness brand online. The lure of the store is the community you interact with while shopping, wine tasting, exercising and socializing. Camaraderie is a powerful selling tool.
Can Luxury Go Virtual?
E-tailer Amazon recently announced that they will be entering the luxury market. Their 2006 acquisition of Shopbop gave them a glimpse into the luxury market, while keeping both sites separate. Of course, the consumer is comfortable buying a $30 pair of shoes on Zappos as the price point is low. But Shopbop has proven that the consumer would also be comfortable buying a $10,000 Zac Posen dress online. As with the brands mentioned above Zac Posen already has a strong following. This is not the case for most brands, luxury or otherwise, that sell online.
Statistically speaking, the conversion rate for in store sales is 67%, while the conversion rate for online sales is a mere 10%. More importantly, online returns range from 15%-50% of sales and 60% of those returns are due to fit. That is a lot of money wasted on shipping and reduced value as apparel goes out of season.
Yes, Amazon’s experiment is ambitious, but 2012 is armed with selling tools that didn’t exist in 2006.
My Digital Doppelgänger
Decoded Fashion included a stellar panel on digital customization. The panel included Acustom, Clothes Horse, Me-ality, and Styku — all focused on helping consumers get the perfect fit. One company missing was Fitiquette, a 3-D avatar-as-model approach created by Cisco alums Andy Pandharikar and Anant Kumar. I believe the digital doppelgänger could be the solution to the pain found in billions lost due to low conversion rates and high returns.
What do you think? Have you used technology to perfect your shopping experience?
During 2007, we witnessed 86 VC-backed IPOs bring in $10.3 billion in fresh capital. Unfortunately, 2008 did not produce the same pay day. With only 6 IPOs yielding $470 million, many feared the party was over. Fear not, 2009 brought a sliver of hope as the number of IPOs doubled to 12, bringing in $1.6 billion. 2010 proved to be a strong year. We were blessed with 75 IPOs, bringing in $7.6 billion. Of course, 2011 would be more of the same, right? Wrong.
The Year of Bloated IPOs
In 2011, we had approximately half the number of IPOS as 2007, yet the amount of capital raised was roughly the same. At first glance, we might think this is a good thing. Actually, this is the worst thing that could have happened. Jumbo IPOs were caused by underwriters propping up prices to unsustainable levels, knowing that the market was hungry for new shares. The average IPO jumped 30% on opening day and stumbled back below opening price. Slumping stock prices acted as a distraction. Management should have been focused on growing the company, not the stock price.
Below is a chart of a few high flying stocks that closed the year below their opening price: Demand Media, Pandora, LinkedIn, Groupon, Zynga and Angie’s List.
Lean and Mean, Miss Diane Greene
Let’s look back at 2007. VMW was the hottest IPO. They went public on August 14, with prior year revenues of $704 million, net income of $87 million and $176 million in cash. The stock opened at $52, rose 90% on the first day and peaked at $107 on November 9. At the end of 2007, the stock closed at $85, up 63% from the opening price. Over the past five years, the share price ebbed and flowed with the markets, but has now settled in the mid $80s. VMW continues to be a healthy company, focused on increasing market share, not market cap.
Pipeline is About to Burst
Currently, there are over 205 companies which have filed to go public. To put this in context, 299 companies filed to go public in all of 2007 and 259 companies filed in 2011. Over the past five years, with the exception of 2008, the percentage of companies that identify as technology companies held steady at approximately 15%. In 2012, we could see well over 50 technology IPOs. Let’s hope they are appropriately priced.
IPOs are Good for America
Historically, 85% of job growth occurs after a healthy IPO. It is critical that we get IPOs priced for sustainability (read: job growth), not quick profit. We want CEOs focused on increasing staff, not bending over backwards to please shareholders clamoring for their “profit.” If CEOs are worried about expenses, they’re less likely to invest in growth. In this scenario, nobody wins.
