How to make sure you know how to make money
Revenue: How do you make money? In this blog we’re going to talk about how you make money. We will find ourselves in the next stage of building our financial model. And at the end, we should have a full set of financials statements.
In case you missed it, in the first article in this series we provided an introductory overview of our simple startup financial model template. And in the second one, we went through the key elements of spreadsheet design. You might recall us talking about making sure that your assumptions can be easily understood and verified.
Do you just want a simple startup financial model template? Click here to get one.
Know how you’re going to make money
In my early entrepreneurial life I had a rather embarrassing experience. We were pitching to prospective investors (me and my two co-founders) and, in the middle of the pitch, I disagreed with the other two on our revenue model. Unsurprisingly, we didn’t get the money that time.
This is something I still often see among many newbie startup founders. So, before you touch a spreadsheet, get your favorite whiteboard marker, pen or crayon and figure out how you’re going to make money.
Your business or revenue model should be something that can be easily and visually shown, and easily understood. I like to see this on a slide right up front in any pitch deck. Right after you’ve shown your problem-solution-product, you can show a potential investor that you know how you’re going monetize the opportunity.
Business model or revenue model?
I’d like to take a moment to talk about how I define the difference between business models and revenue models. The terms can, somewhat confusingly, be used interchangeably.
For those of you new to the startup scene, you may want to first check out the (now) “classic” text on Business Model Generation by Alexander Osterwalder. In this book, you will be taken through the principles of building your Business Model Canvas. It’s a great technique, and you end up with a simple one-page visualisation of all of the key elements of your business.
As you can see, the business model canvas has nine different elements. The segments include such elements as defining your customer segments, channels, and partnerships. And it includes a space for your revenue streams and cost structures.
This is the point. I see that a business model should more correctly be defined as a business operating framework. That framework should include all nine elements included in a business model canvas.
Your business model is your ‘business operating framework.
In contrast, a revenue model “merely” focuses on the numbers. It is mostly about the revenue (obviously). But is potentially includes some of the direct costs associated with earning the revenue. This is what accountants sometimes call cost of sales.
What is revenue?
Revenue is the number of units, multiplied by the price of those units.
Sounds easy, right?
Patrick from Price Intelligently rightly describes pricing as an art as well as a science.
Your price needs to match the buyer’s perceived value.
And therein lies some of the art. You are trying to guess what value people get from the product or service you’re offering. And you’re trying to see that from their perspective.
Salesforce charge $250 per seat per month. Compared to cheaper CRMs at $25-$50 per month it has arguably the same functionality. In the case of both Salesforce and its cheaper competitors, the incremental cost of a new user is probably less than $0.01 in any direct sense.
So the stronger your brand is the more you can hold with higher prices. But that doesn’t help you much when you’re a new startup!
The Salesforce example is a reminder that while you should understand your cost per user, this should not be the only consideration when setting a price.
Another area you should look at is comparables.
If there are some direct competitors out there you should definitely understand how they price their offerings. And I say understand not just copy. If you truly believe you have a better offering then, by rights, your price should be higher.
Be careful, too, if your only point of difference is that you just want to charge less. This is rarely a sustainable basis of competition for the long haul. That is, unless you’re also very sure that you can deliver sustainably with a low cost.
Thinking about comparables means putting yourself in the shoes of your customers and thinking a little laterally.
We all have an internal barometer on price that gives us a sense of what is “reasonable”. Trying to charge $10,000 for a watch sets the expectation that it had better be a very good (even gold-plated) watch, whereas charging only $1 raises everyone’s “this is too good to be true and there’s probably something wrong” flags.
Think about similar but alternative offerings. If you’re a food home delivery service, for example, customers will be comparing you to the cost of a meal at a restaurant, as well as the cost of groceries. Customers evaluating Netflix will compare to the price of going out to a movie, renting a video or potentially even the cost of alternative entertainment like going to see a football game.
It can also be easier to price in a way that people are familiar with or used to. If people have to decipher a “weird” (ie new) way of being charged, it can be a blocker to making a decision.
Pricing is all customer value. Price is what you pay. Value is what you get.
Of course this doesn’t consider evolutionary business models. An example was when Xerox went from selling physical photocopiers to charging on a cent per page basis. So, there are cases where the business model in effect defines the business as a whole.
Well that wasn’t so hard, was it!
Now onto the other aspect of estimating revenue: Number of units sold.
How to estimate sales volume (or number of units)
I really like the guys over at Board of Innovation. They’ve put together, curated examples of B2C and B2B revenue models, as well as a slideshare on How to choose the right business model. Check out their resources for ideas of revenue models you might want to use for inspiration for your own business. They’ve also “nailed it” in how they help you to visually present the key aspects of your revenue model per the Dropbox example below.
Pioneers in the cloud storage space, you can see all the elements of Dropbox’s freemium business model where they offer free disk space for signing up and referring friends. Ultimately, this leads to paying customers. Remember, customers are those that pay: Everyone else is just a user.
What’s also noteworthy is that you can easily see that there are elements of the Dropbox business that are pure cost, all of which need to be considered from a modeling perspective. To give you some idea of the perspective here, only 130,000 of the 8 million business customers Dropbox has actually pay (that’s only 1.8%).
If you are considering a freemium business model, you should also check out Andrew Chen’s post specifically on How to create a profitable Freemium startup.
This then leads you to start to ask (and answer) the operational question of how you’re actually going to get customers. What is the (acquisition) journey you plan to take them on? Are you an offline business with a field force of salespeople, or do you have an online customer acquisition plan?
As you start to consider the customer journey, this leads you to consider the likelihood that your potential customers progress through the various stages of your customer pipeline. This happens before they finally become real paying customers. A good example of this can be seen in Dave McClure’s Startup Metrics for Pirates. You might set a Google Adwords or Facebook Advertising budget to fill the top of your pipeline, and then through the various stages of calls to action once they get to your website, etc they ultimately sign up for the service you’re offering.
In your financial model you want to reflect the various conversion ratios you estimate will happen along the customer acquisition journey. Remember: Financial models (in total) are a best attempt to put together a consistent, financial representation of the planned (total) performance of the business. And the revenue section of the financial model is a best attempt to put together a consistent, financial representation of the planned or expected customer acquisition strategy.
Given that these ratios are your expected conversion ratios, they are then the metrics you should be (operationally) monitoring as you go forward with your business. In monitoring real performance against the modelled assumptions, you can look to see whether your assumptions were real, or whether there are ways you may need to improve the actual conversion ratios if they fall below target. For example, could you introduce a chat window on your website to improve conversion.
So I haven’t actually talked about units sold yet! I’ve pretty well just talked about plans and process. This is for a good reason: As I pointed out in the last article, it’s the plan that drives the numbers. The same holds true in revenue, because how much you sell depends on both (a) having a plan of how you’re going to sell, and (b) committing to the resources necessary to deliver on the plan.
Your plan drives your numbers – even in terms of revenue.
The actual quantities of your sales are assumptions. But they are ideally a more considered and detailed outcome of working through the process of acquiring customers.
Other considerations in your revenue model
Onboarding costs. While you’re thinking operationally about what it takes to get your customers, you should have all the information you need to put a cost on it. This customer acquisition cost (CAC) is one of the questions that potential investors might ask you.
Churn. If you’re a SaaS business with monthly recurring revenues (MRR), one of the other aspects you also need to consider and model is estimating the number of customers you expect to lose, or what they call churn. Of course you’re going to do as much as possible to keep this small, but 1) it’s inevitable, and 2) this becomes a key metric for your ongoing monitoring.
City-by-city roll-out. If you’re the kind of business that is planning a city-by-by rollout like Uber, then you first want to build a financial model that looks at what it takes to grow that business in a single location. Then, having figured out a single city, model the timing of your your city-by-city rollout plan as you scale.
The prices you charge, and related direct costs, are the powerhouse of your business.
These unit economics define what accountants call the gross profit (that is, profit before all of your indirect costs spent on sales & support, development and overheads). Getting this right is critical to ensuring the long term sustainability of your business, so give pricing the attention it deserves.
What about the template?
Oh yeah, nearly forgot. This blog is supposed to be about the template, right? Well actually, no.
If you’ve stuck with me this long by now you probably already realise that it’s the thinking and planning that are more important. Nevertheless, the template does include examples of both a physical product sale + cost as well as a subscription model.