The 5 most important numbers in your business plan, part 3.

May 6, 2010

Long term financial projections for a startup are pretty much always wrong. After all, if an army of financial analysts can’t predict next quarter’s revenue projections for a company like Apple that’s been around for 30 years, how are you expected to forecast your monthly profits five years out, for a company with no track record?

Still, it’s worth building a financial model that incorporates your best estimates – for yourself, and for partners and investors. In previous posts, we discussed the importance of:

1.) marketing efficiency, and

2). break-even

Here are some other numbers that are particularly useful:

3.) Scale. Have a ballpark prediction for what your annual revenue will be after five years. While you won’t get the number right, you should be able to predict the order of magnitude (e.g. are you shooting for sales of $1 million? $10 million? $100 million?) That will be help investors, partners, and other stakeholders grasp the size of your opportunity and help them to know that if things go well, the rewards will be worth the risks. Also, make sure your scale is reasonable, by looking at comparable companies. How long did it take them to reach a similar size, and how much did it cost them?

4.) Capital requirements. Have a prediction for the timing and amount of investment capital that will be required to get the company through the next five years. Raising capital is difficult and time-consuming, so you should avoid any surprises on this front. Also, understand and demonstrate how you’ll spend your investment dollars. They’ll want to know what you plan to do with their money.

5.) X-factor assumptions. You’ll base your projections on many assumptions. One or two of them, when modified slightly, change your projections dramatically (e.g. the cost of acquiring an average customer or the amount of revenue generated by an average transaction). Also, know which assumptions are common to your industry and make sure your numbers are in line with standards (e.g.those might include markups, or sales per square foot in retail).


The 5 most important numbers in your business plan, part 2.

May 6, 2010

In part one of this series, we looked at marketing efficiency. In this post, we’ll look at break-even.

One sure-fire way to kill your startup is by running out of cash. The risk is greatest in the early days, before your company is profitable. That’s why you’ll want to pay close attention to break-even. That’s the point in time when cash from operations stops flowing out of your business, and starts flowing in.

If you are in the planning stage, estimate when you’ll reach break-even, and how many transactions per month you’ll need to get there, also known as break-even volume. Once your company is up and running, track your progress toward break-even, and consider it a critical early milestone.

To estimate when you’ll reach break-even, start by calculating the unit contribution, or margin, generated by one sale or transaction. To do that, figure out your revenues from one transaction, and subtract the costs linked directly to one transaction, aka “variable costs” (e.g. sales commissions and costs of producing the product, aka “cost of goods”).

Next, calculate your monthly overhead—operating costs that don’t vary directly with sales volume (e.g. rent, salaries, utilities, legal and accounting expenses, etc.). If you are still in the planning phase, project your monthly overhead for a future period, such as after 12 months.

Finally, divide your monthly overhead by your unit contribution. That will tell you how many units you’ll have to sell to cover your overhead, or break-even. When do you think you’ll reach that level of sales? The answers to those questions will tell you, and potential investors, more than most fancy long term projections.


The 5 most important numbers in your business plan, part 1.

May 6, 2010

In order to run a profitable business, you’ve got to get more from each customer than it costs you to attract them. Another term for this is marketing efficiency, which is the relationship between two numbers:  1) The cost of acquiring an average customer, and 2) the lifetime value of an average customer.

If you area planning your business, and haven’t launched yet, set a goal for your marketing efficiency. Once your company is up and running, make marketing efficiency one of the key performance measurements you track on an ongoing basis.

Here’s how to do the math…. Look at the numbers for a set period of time, like six months. What are the total costs of sales and marketing for those months, including marketing expenses, salaries and commissions of marketing staff? How many new customers did you attract in those months? Divide the costs by the number of customers, and you have your customer acquisition cost.

To determine the lifetime value of a customer, start by calculating or estimating how long a relationship with an average customer will last. Then estimate the amount of revenue you’ll generate per customer, over your entire relationship with that customer, and subtract the variable costs of delivering your products or services to an average customer, including the costs of service and support and the cost of employees providing the service and support.

Finally, divide the lifetime value per customer by the cost of acquiring a customer. Shoot for having a lifetime value at least three times greater than your acquisition cost.

How efficient is your marketing?


Lifetime value of a customer

November 19, 2009

If you’ve got any interest in marketing, you should be reading Seth Godin’s blog. Today, he talks about the lifetime value of customers.

When planning a new business, it’s easy to get mired in the weeds of complex financial projections – that are nearly almost wrong. But very often, so-called back of the envelop numbers are more useful and accurate. For example, unit contribution, and break-even volume. Understanding the costs of acquiring an average customer and the lifetime value of that customer are also at the top of the list, especially for companies with large numbers of customers. Here’s an excerpt from Seth’s take:

If you walk into a company-owned cell phone store to sign up for a contract, what are you worth? Given the huge gross margins at AT&T and Verizon and the standard two-year contract, I think it’s easy to figure on more than $2000 in lifetime value…

Few businesses understand (really understand) just how much a customer is worth. Add to this the additional profit you get from a delighted customer spreading the word–it can easily double or triple the lifetime value.

So, a chiropractor might see a new patient being worth $2,500, easily. And yet… how much is she spending on courting, catering to and seducing that new customer? My guess is that $50 feels like a lot to the doc. Instead of comparing what you invest to the benefit you receive from the first bill, the first visit, the first transaction, it’s important to not only recognize but embrace the true lifetime value of one more customer.

Write it down. Post it on the wall. What would happen if you spent 100% of that amount on each of your next ten new customers? That’s more money than you have to spend right now, I know that, but what would happen? Imagine how fast you would grow, how quickly the word would spread.

Here’s how you’ll know when you’ve really embraced this–a good customer at your podiatry practice (or supermarket or tax firm) walks out the door in a huff and you turn to your partner and say, “There goes $74,000.”


Projection direction: Build bottom-up, check top-down.

May 14, 2009

Before you can select snapshots of financials to include in your pitch, you’ll need to build your financial model—typically in MS Excel. If you don’t have expertise in finance, accounting and Excel, you should probably get help from someone who does, preferably someone with experience building projections for startups.[1] Whether you build the model or get help, be sure to follow this simple rule: Build from the bottom up, and validate from the top down.

Building from the bottom up means starting with the details of each item, and extrapolating from there. Top down means looking at the overall market, and makes assumptions about how your company will fit in. For example, let’s say you are projecting sales for a Widget company (“Widget Co.”). Start with a bottom-up calculation, like this:

BOTTOM UP CALCULATION: WIDGET CO. SALES REVENUE, JANUARY 2011

Number of sales reps 5
Sales calls per rep 40 per day * 5 days/week * 4 weeks = 800 calls per month
Percent of calls that generate sales 15%
# of sales closed per month 120
Average product price $100
Average # products sold per transaction 5
Average transaction size $500
Sales revenue /  month 120 transactions * $500 per sale =  

$60,000 

Then make sure your numbers are realistic by doing a calculation like this, and considering whether a 2% market share is realistic at that point in time:

 

TOP DOWN CALCULATION: WIDGET CO SALES REVENUE, JANUARY 20011

Sales revenue for entire market, per year $36,000,000
Projected market share for Widget Co. 2%
Projected sales for Widget Co. $720,000 per year / 12 = $60,000 per month

 

Turning to the example of marketing expenses, start with a bottom-up calculation like this:

 

BOTTOM-UP CALCULATION: WIDGET CO. MARKETING EXPENSE, JANUARY 20011

Cost of leads per month $12 per online lead * 800 leads = $9,600
Brochure cost per month 800 sales calls * 1 brochure to each prospect * $2 per brochure = $1,600 per month
Cost of industry events per month 2 events attended per month * $1,500 per event = $3,000 per month
Marketing expense / month $9,600 + $1,600 + $3,000 = $14,200

 

Then give your numbers a reality check with a top-down calculation like this:

 

TOP-DOWN CALCULATION: WIDGET CO MARKETING EXPENSE, JANUARY 20011

Marketing costs as a percentage of sales, based on industry standards 23.4%
Sales per month $60,000
Marketing expense / month 23% * $60,000 = $14,040

 


[1] Many entrepreneurs without financial backgrounds get help from investment bankers. Sometimes these bankers create models so complicated that the entrepreneurs never truly understand how they function, and have trouble explaining them to investors and modifying them.


Slide 10: Financial projections (Part 3)

May 14, 2009

… continued from part 2.  The third thing your audience wants to know from this slide is:

3. How are you spending the money? If you are asking an investor for a check, they’ll want to know how you’ll use it. If you will be projecting your slides, do this with a “use of proceeds” chart, showing that out of $X million raised, you’ll spend Y% on marketing, Z% on product development, etc. If you will be making your presentation from printed documents, your audience will be able to see the fine print. Include a monthly P&L (projected statement of profit and loss) basis for the first year of operations. That way, a prospective investor can see exactly where your revenue will come from, and where their money is being spent, during the critical first 12 months.


Slide 10: Financial projections (part 2)

May 14, 2009

(continued from part 1) The second thing your audience wants to know from this slide is:

2. Are your numbers realistic? Next to your big picture view, you’ll want to highlight some key assumptions and metrics. These will vary depending on your business. In each case, they’ll let your audience know what drives your numbers, and assess whether you are being realistic. Wherever possible, you’ll want to provide reality checks. For example:

Assumption / Metric Reality check.
It will take six months to develop our website using an outsourced vendor, at a cost of $200,000. We have bids from three vendors who have built similar websites before, and they are all safely within that range. We verified these numbers with their client references.
On average, it will take us 60 days to close a sale.  According to our advisors, our two competitors had sales cycles of about 60 days at our stage of development.
The average customer will renew their subscriptions for 180 days. This is an industry standard, as reported by ABC Industry Association.
Our margins will increase over time, because our revenue will grow faster than our expenses. At the end of Year 5, we’ll have margins of 40%. These margins are in-line with the numbers in our competitor’s annual report for their 5th year of operations.
We will reach sales of $10 million by the end of year three, which will give us about a 2% market share. Our closest competitor hit sales of $10 million after 3 years of operations.