Financial Modeling

WHY IT IS NEEDED

Once the rationale of the business is presented in business model canvas the essential question needs to be answered – how much money do we need to launch and how we are going to earn the money? It is important to understand what is the future of your business when referring to its financial situation. Of course, it is hard to predict the future especially when many variabilities are related to it and you can come up with the question – why do you need to do this. If you are the (co)founder of a startup you need to have an understanding of:

  • What is your revenue model?
  • What are the cost and how much do you need to start?
  • How much do you need to keep going?
  • When you will run out of money?
  • What the future of your startup might look like?

To sum up, you need to know the vision of the startup. For example, if the startup needs money, you should try to know where to get it. There are plenty of option, like investors, venture capital funds, business angels, lenders, maybe even from customers. All of them will ask you about the vision of your startup and such critical things as the value proposition, customers of your business etc. However, at the end of the day, they will be mostly interested in the economic return of the money they would potentially give. That is why you need to do your homework with the financial part of your business.

REVENUE MODELS

A revenue model describes the way business generates its income from the customers. There are quite a few revenue models the startup can choose from. Just to present you with some examples:

expenses covers the money that are necessary to develop a prototype of the product and eventually to make a final and go-to-market product. For example, if you intend to produce innovative medical device, you will need a significant amount of money to implement R&D process, clinical trials etc. At the same time, do not forget the expenses that are necessary for market research. You can do it while using internal human resources or you can hire market research company. Even if you conduct the research by yourself, you will need to gather and process a lot of information that can be quite costly to get

is a flexible consumption revenue model that is getting popular both within media market (like TV, online services) and durable goods/services (e.g. car sharing “Citybee”, “Uber”). When applying such revenue model, company meters and charges the customer for exactly what he or she have used.

when a company charges its customers the recurring fee for product or service. It is an ideal solution when customer uses your product/service on a regular basis. The value of this model is that customer does not need to spend a lot of time when constantly buying the product/service as they receive it regularly. Besides, subscription allow the company to offer a better price for the consumer (than buying the same product/service several times or separately) at the same enabling the company to enjoy financial predictability, assuring the inflow of money necessary for the company to operate and develop. The examples of such revenue model can be Netflix, sports club, newspapers/journals (online too) etc.

when the offering the product, e.g. printer, Nespresso machine or razor stick for a very attractive price (sometimes even lower than its costs) while at the same time asking the consumer to pay relatively high price for the expensive supplies – ink cartridges, coffee capsules or the blades for shaving that need to be continuously replaced.

this revenue model means that a company provides basic product/services for free, however asks to pay for any additional premium functions, features etc. An example of such revenue model could be such companies as Dropbox, LinkedIn, Economist. Dropbox provides a certain amount of cloud storage where you can keep your data free of charge, however when you will use the storage provided for free, you will be asked to pay certain amount of money for additional storage. Very popular online journal Economist (digital form) is also a good example of such revenue model, as they allow for non-registered users to read two articles per week, for registered users three articles per week, whereas subscribers of the journal can read unlimited amount of articles. However, this model requires a lot of work and investments to reach the critical mass of the customers/users and latter to differentiate them while selling the premium services for those users who are locked-in as free.

can be applied when the value of the product or savings that the product provides for its customer is considerably higher. It enables to charge a higher price, corresponding to the value your product delivers for the customer. An example of such revenue model can be new drugs that provide treatment and solve such health problems that were not solved before with other medicine.

revenue model allows company to generate its revenues (or the majority of it) from advertising. Many companies sell both goods and services (combined or separate) and use online shops to reach their customers. At this point, advertisers can be seen as a very attractive source of revenue. There are many online businesses, which provide their products/services for free (e.g. various apps for mobile phones, online products etc.), especially as users are not willing to pay for something they can find free of charge. However, its worth keeping in mind that company has to create certain value proposition that would generate big interest and large flow of traffic which would be an attractive place for advertisers.

DETERMINE THE PRICE

The product/service to be offered for solving the customer problem is the starting point of your company and was already discussed earlier. Once the service/product addresses the actual customer need that the customer is willing to pay for, the next important step is determining the price that the customer may be willing to pay. There are several approaches for determining the price that can be based on such elements as competition, target market, place, promotion and other internal and external factors. Let us discuss some elements in more detailed.

  • By now, you have already conducted market research and are well acquainted with other products/services that are identical, similar or substitutes for what you offer. It means you know the price range of the products/services offered by the competitors. There is an established principles saying a) if the product is unique, characterized by clear competitive advantage, you can charge higher price; b) when entering the competitive market you have to take into account the prices of your competitors and sometimes it means you have to charge less. Considering the latter statement, small business often find it difficult to compete on price with the large business as usually they have higher numbers in sales and greater economies of scale.
  • It would be fantastic to know the exact price the customers are willing to pay, however, there is no miraculous way for determining it. At this stage, the best thing to do is research. Simply go and talk with potential customers, and observe their reactions to the prices of your product/service. If they find your price too low, try raising it. On the other hand, customers set the “price ceiling”. If it is too high, you can either try to find the way to reduce the price or even better – try to demonstrate the value and benefits of the product/service and make the customer realize that it is worth to invest in it.
  • Other factors you should keep in mind when determining the price are suppliers, technology, labour force, economy. When all the costs needed to determine the price are calculated, you know the “price floor” and it is time to add a margin for profit. Profit your company will earn will help to keep the business alive and to develop it into a successful company. Do not underestimate the importance of the margin, because many startups miscalculate their costs and are unable to pay their bills what eventually leads to the closure of the company.
  • Pricing can make your startup a successful company or a failure. Do your homework and hopefully you will set the right price. However, remember that the final price of your product/service does not have to be determined by the cost incurred. If your startup is offering a high-quality or innovative product/service don’t set too low price while expecting to gain a certain market share. It might lead to a situation when the potential customers perceive the offering as being of lower quality. Moreover, your startups price strategy should correspond to the customer segment. So to say, if you seek a price-sensitive customer it means you are a low-cost provider. However, there is a big pool of customers who are not price sensitive, but “benefit” sensitive. These customers are ready to pay more for a product/service that offers greater benefit.

WHAT ABOUT THE COSTS?

However, a starting point is always by calculating the costs the startup will experience for making the product/service. The following costs are generic and common to all business types, regardless of the company‘s scope of activities:

such revenue model means that the startup company does not use any kind of intermediaries, distributors and sell their products directly to the end consumers. Such model enables a company to not only control its sales force and build personal and meaningful relations with the consumer, but also to increase the profit margins by cutting out the intermediaries.

covers such costs as website creation, software your startup will use on a daily basis (accounting, payroll). However, if you notice these expenses are too high to buy it, there is a possibility to outsource these functions and thus to save some money.

expenses are in the costs list of every startup. It covers such things as office space, inventory, office furniture, utilities and all the necessary supplies. At this point the key question and the decision you have to make – to lease or to buy. Answer to this question depends on your financial situation. However, keep in mind that startup very often does not have stable income and the leasing option can be a better decision in the beginning while the decision to buy might be left for the latter period. Even so, carefully check the terms of the leasing.

covers the salaries of the people who are working in a startup. It happens very often that in the very beginning, the founding team of the startup work without pay with the expectations to successfully launch the product and then start paying the salaries and other benefits. However, such strategy has its limitations because eventually people start questioning such situation (especially if they do not see the light at the end of the tunnel when launching the startup) and the people drop out.

of a startup (generally speaking – Marketing) is much more than an ad on the website or online advertising. These costs covers everything the startup does to attract and to keep the customers. If you are a small company with limited human resources, you might consider outsourcing these expenses as well when hiring the professional company of freelancer specialist to do it. Do not underestimate the importance of marketing, especially as these expenses might have a fundamental influence to your sales numbers. It happens when startup develops very good, innovative product/service and do not allocate enough money for the marketing activities what results in low sales and poor awareness of the product by potential customers. The key message here is that no matter how good the product is, if it will not be properly advertised, promoted and sold, all your efforts you have made to produce it will be meaningless.

such as various licences, permits, patents fees, insurance deposits etc. also worth to consider to include into the list of the costs.

Calculate all the above-mentioned costs and note they should be taken into account when determining the price of your product or service. Some of the costs are fixed (you will spend each month, e.g. office space rent) whereas others are variable (e.g. employees number might grow together with your company).

The advice here would be to think carefully and responsibly about the things you really need. At an early stage of a company, fixed costs should be as small as possible as you will need to spend a lot on such variable costs as marketing. It happens when the founders of the startup buy not indispensable things (e.g. latest version of Apple iPhone or MacBook) that do not generate any significant value for the business.

Innovative ways of minimising the costs of start-up operations (at no expense to the value provided to the customer).

There can be some innovative solutions for cost optimisation in order not to compromise the value proposition. Some examples for achieving the target cost:

As you are designing the new business model, you can question the very presence of certain cost areas. Are they really indispensable? Can we design such value proposition (to our group of customers) where the traditional cost areas in our industry simply get eliminated? For example, do you really need to own the cars to be the largest provider of taxi services?

This is a classical way of cost reduction by outsourcing the expensive and strategically non-essential activities to the partners in your value network. Nowadays, it is a common practice to outsource the activities related to the fixed costs (e.g. equipment, physical facilities, manufacturing) to the external partners that are specifically focused on these activities and help achieve cost optimisation.

Some of the important cost savings are achieved by eliminating the redundant intermediaries (“cutting out the middleman”), standardisation and automation of internal processes. You can also reduce the cost of some important elements in your production line, e.g. introducing new materials that serve slightly different value proposition (the case of Swatch that optimised the cost of Swiss watches by introducing the plastic parts while at the same time turning them into fashion items)

You can also ask yourself a question if you are approaching the cost optimisation issues from the correct price perspective.

  • You can introduce a time share model where potential consumers are asked to pay not for the entire product (i.e. thus suffering a heavy price and refusing to become your customers), but only for the time that this product is used. In this way, rental and sharing businesses replace the traditional businesses focused on selling the ownership to the product.
  • You can introduce a slice share model where you sell only a minor share of the whole product, but this way it becomes more attractive and less expensive to the customer.
  • There is also a possibility for barter, i.e. directly exchanging the goods and services without using the financial means. Some businesses have insufficient, while other redundant resources that they both need and can exchange depending on the situation. It can also lead to important cost savings.

It is also important to keep in mind that the issues of cost optimisation will be more pronounced if your business is cost-focused (e.g. low price is the key aspect in your value proposition). If your business is more value-focused, i.e. providing the customers with a distinctive value, then the cost-related issues will be less important. The main question in the latter case will be – how to provide the best value to the customer? Here, the issues of customer service, relationship and new product development will be of a greater importance than cost optimisation (e.g. through economies of scale, eliminating the intermediaries, etc.)

CALCULATE THE MONEY

Once you have decided which revenue model is most suitable for your startup, and determined the price of the product/service, it is worth to think about break-even analysis. This tool is generally used for calculating the level of sales that are necessary to cover the costs of the company. In other words, it is the point where revenues are equal to the costs (needed to generate them), and company makes neither profit, nor loss. The break-even point will be lower for the startups with lower fixed costs. Hence, below break-even point the costs exceed the revenues of the startup, it means company experience losses, whereas above the break-even point company’s revenues surpass the costs and company makes profit. Having this information is very useful for the managers, who usually want to know what the break-even point is at different periods of time – week, month, year. It enables them to plan sales volumes to achieve the target profit.

Fill in the table below and calculate the break-even analysis in three different scenarios – optimistic, realistic and pessimistic. After completing this task, you will be able to see how much units you need to sell in one month, in order to reach the break-even point.

How much money do you need to start – this is the final question you need to answer. Before launching a startup you have to know how much money in cash you should have for the first 6-12 months, in order to cover all the expenses, while company (usually) does not generate enough sales.

Work on the numbers and forecast the sales and costs (of those sales) and other expenses by month for the next 12 months. Make it reasonable. When establishing new business, it might seem complicated to forecast the sales volume of something that is still not on the market. At this point, do some research, look for a similar product and use the data for your own forecasting. Besides, think about your sales under different circumstances, i.e. if you spend more on advertising your sales should increase as well.

Fill in the table below and forecast your startup’s cash flow (fill in the table below) in order to see when your company should become profitable. If you find there is a very (too) long period needed to reach the break-even point, think about the possibilities to make it lower. You can try to look for the ways to increase the price or to cut off fixed costs and unnecessary expenses.

Available to download Forecast your startups cash flow

THE RESULTS

After completing this chapter, you will have an understanding about the finances of your startup:

  • What are your start-ups’ fixed costs, variable costs and other expenses?
  • What is your break-even point in optimistic, realistic and pessimistic scenarios?
  • How does the cash flow of your startup will look like monthly for 12 months?

Final note – your calculations have to be flexible enough to account for the fast changing situation in your start-ups early life. You can even change your cost and revenue models in the process to find the one that works best for your company and its customers.