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.
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