How to Build a Startup Revenue Model (and not feel like you’re making sh*t up)

I’ve written about general guidelines for financial modeling and specific tactical tips, but I’ve neglected to address an important question: what’s the best way to structure your revenue model? Modeling expenses is fairly straightforward, but many of the first-time founders I work with feel uncomfortable making a revenue forecast, as if they’re pulling numbers out of thin air. And that can be the case without a systematic approach to modeling. In this post, I’ll introduce a structured approach to help ground your revenue model in more tangible assumptions (and make it feel less like made up nonsense).

Determine your customer acquisition model.
Before you can generate revenue, you have to acquire customers. There are a wide variety of different customer acquisition models, but for our purposes they fall into three broad categories:

• Direct: Your company has direct contact with the end users of your product. This typically means employing salespeople who engage directly with and sell to customers. This tends to work best for products that command a high price. Examples: Tesla, Palantir, Boeing.
• Indirect: Your company does not have direct contact with the end consumer of the product. Indirect customer acquisition takes numerous forms including retail sales, channel partnerships, independent dealerships, consultants, etc. Examples: Mattel, Ford, Oracle, Coca-Cola.
• Inbound: Customers to serve themselves with little to no contact with anyone within your company. This typically requires driving traffic to a website or app with streamlined sign-up and payment interfaces. This works best for low-priced items that customers can easily understand (or are willing to take a risk on). Examples: Netflix, Amazon, Spotify.

Model your customer acquisition funnel
After you understand your customer acquisition model, it’s time to model your customer acquisition funnel. You can view every customer acquisition model as a funnel that begins with potential customers and ends with actual paying customers. You lose potential customers at various steps along the way. The generic form appears below:

For an inbound customer acquisition model, the structure might look something like this:

We can translate that to Excel with simple assumptions around attrition at each stage of the funnel. The figure below illustrates an example for an inbound funnel.

Let’s look at one more example for a direct sales people, translated directly to Excel. In this case, we condensed several steps of the funnel and made a simple assumption around the number of deals a single salesperson can close each month, the number of salespeople on the team, and the time required for a salesperson to reach full productivity.

The key point to recognize with any customer acquisition model is that customer acquisition relates to expenses. If you spend more on advertising in the inbound model or hire more sales people in the direct model, you acquire more customers.

Determine your revenue model
Now that you know how to acquire customers, we need to figure out how you’re going to charge them. I’m calling that a revenue model. For our purposes, there are two broad types of revenue model which are independent of how you acquire customers.

• Transactional: Charge customers on a per transaction basis. They have no ongoing obligation to purchase from you again. Examples: Tesla, Apple (hardware), Starbucks
• Recurring: Charge customers a monthly or annual subscription fee for ongoing service. Examples: Netflix, Comcast, Blue Apron

All things being equal, recurring revenue is preferable because it is more predictable and you don’t have to re-acquire customers over and over again.

Combine the customer acquisition and revenue models to get revenue
Remember, the customer acquisition model and revenue model are independent, so we can develop six different permutations based on the building blocks above.

In both types of revenue models, revenue depends on the number of units sold, but in a slightly different way. I use the term “units” generically to mean whatever drives your pricing (subscriptions, users, pieces of hardware, etc.)

In a transactional revenue model:

Revenue = New Units Sold x Price

A recurring revenue model is slightly more complicated. Revenue is based on the number of active subscribers. Subscribers can cancel their subscription, so we must track the cumulative number of customers who haven’t cancelled. Assuming a monthly subscription:

Monthly Recurring Revenue (MRR)= Cumulative Subscribers x Monthly Price

Where

Ending MRR= Beginning MRR+ New MRR — Churned MRR

Churned MRR = Beginning MRR x Monthly Churn Rate

Where Monthly Churn Rate represents the percentage of monthly recurring revenue lost to cancellations each month.

Combining all of these elements for the inbound customer acquisition model discussed above yields the model shown below.

The revenue projection is grounded in realistic assumptions that can be tested, validated, and updated as necessary. Furthermore, spending drives revenue growth so all things being equal, spending more on sales and marketing increases revenue growth. You’ll have to refine things as you go, but at a pre-revenue or early revenue stage, this is a great way to model revenue in a structured, systematic way.

Note: I simplified a number of things for this blog post, but this should start you down the right path. If you’re interested in learning more, check out my free (pay what you want) eBook — The Founder’s Guide to Financial Modeling. It provides more detail and a step-by-step walk-through for building a full model and a sample Excel model to illustrate key ideas.