The Launch Path - Step 5.
Create an Economic Model
Spreadsheets! And then more spreadsheets!
You may love spreadsheets or you may hate them. But your venture will probably sink or swim depending on whether the numbers work. So we better start the process of creating a sustainable economic model for your startup — sooner rather than later.
Many first-time entrepreneurs freeze-up at the thought of creating spreadsheets for their startup venture. Sometimes it’s because of a lifelong aversion to numbers, sometimes it’s because they think it requires a CPA’s knowledge of GAAP accounting, sometimes it’s because they feel they can’t do it until they know the “exact numbers” to put in there.
My advice is to get over all of that, and just dive in. Getting it exactly right isn’t as important as just getting it going.
Yes, you actually need to do this.
There is mythology that early-stage investors don’t care about a full economic model, just like they don’t care about formal business plans anymore. But every investor I know wants to understand how the economics of the venture might work out, and most importantly they want to invest in an entrepreneur who has actually spent some time thinking through the economics. So yes, you need to do this (even if it’s just for yourself).
Don’t worry about all the numbers being right — they won’t be.
For your economic model we’ll use the same methodology as we did with the Business Model Canvas — just put your best guesses on there and then figure out how to test them and refine them. Of course your first set of numbers will be wrong — everyone’s is! But if we build the model correctly we can easily iterate on the numbers as we go along.
These are not financial statements.
Remember that we are building an economic model, not financial statements. Financial statements are backward-facing documents to report on what happened last year for reporting and tax purposes. What we are creating is a forward-looking model of what the economics of our venture might look like. We don’t care about GAAP accounting rules, depreciation tables, or accrual methods. All we care about with an early-stage startup is cash-in, cash-out – that’s it.
As part of this exercise, we’ll be looking at what the unit economics are for our startup. The finances of every venture distill down to unit economics — what does one unit cost us to make and sell? For a bakery one unit is a loaf of bread, for a consulting firm it’s a hour of time, for an airline it’s a seat-mile. Think about what one unit is for your startup. Too many ventures find out too late that the unit economics don’t work and they don’t improve with scale. That’s a death knell, so let’s avoid that.
CAC < LTV
Based on our unit economics, we need to estimate what it will cost us to get a customer (Customer Acquisition Cost, or CAC) and once we have a customer what we will make from them, over the lifetime of our relationship with them (Lifetime Value of a Customer, or LTV). In order to have a sustainable business, we have to be able to get new customers at a cost less than what we can make from them. Customer acquisition cost must eventually be less than the lifetime value of a customer. It’s a very simple concept, and yet getting this upside down remains a leading cause of startup death.
Once we get a functioning economic model of our venture, we’ll be able to do some sensitivity analysis. What are the numbers on the spreadsheet that really make a huge difference in outcomes? For some businesses, getting the product manufacturing cost down by five cents makes a huge difference. For others, it might be making the marketing more cost-efficient. Once we’ve built a good economic model, we’ll be able to understand these things better.
Ladies and Gentlemen, start your spreadsheets.
So let’s take a look at creating an initial set of spreadsheets for our startup. Some people would call these “financial projections”, but I like to refer to them as the economic model — the economic rationale by which you to expect to create, deliver, and capture value for your customers (if this sounds familiar to you, it’s because it’s also my definition of a business model).
These spreadsheets will of course contain projections — projections of what you think your costs will be and projections of what you think the revenue will be. But to sell an investor (or yourself) on the notion that this venture will work, it’s not about wild-ass guesses of what revenue in Year 4 will be, it’s about making sure that there is a fundamental economic model that suggests this can be a company built to last. The basic economics of the operation have to work.
The point of a financial model is to tell a story with numbers — a story about opportunity, resource requirements, market forces, growth, milestone achievements, and profits.
– Guy Kawasaki
I like to do the Business Model Canvas for a new venture first, so that I’ve got a reasonably good picture in my head of what the elements of this particular venture are, and then use that to inform that creation of a spreadsheet that represents the economic model.
I like to separate everything onto separate tabs in my spreadsheet, to keep everything simple and easy to navigate around. Here are the tabs in my example economic model:
Put your assumptions on one tab, and that way you can change them once there and see how they flow through the entire model. An example might be “average order size” or “credit card fee”. If we’re assuming that we’ll be paying a credit card fee of 3% and then later we get a good deal with the bank and can get that down to 1.85%, you can just change it on the assumption tab and it will automatically flow everywhere else. Or maybe we’re assuming an average order size of $50, and we want to see how everything changes if we get that average order size up to $57.
There are usual “Setup costs” to get a venture going. You’ll have to form a corporation, consult with a CPA, build an initial website, etc. I like to put these on a separate tab as these are 1-time non-recurring costs, not part of ongoing operating costs.
Cost of Goods Sold (COGS) is the traditional way of representing what the products you sold cost you to make/buy. So if we sold 100 loaves of bread for $1,000, the COGS include the flour, water, yeast, salt, and labor costs in making those 100 loaves. So COGS is not the “overhead” costs in running the organization, it’s just the costs in making the products you sold. So you, as CEO, are overhead, whereas the guy mixing bread dough all day is part of the COGS required to make each loaf of bread you sell. Sometimes you will hear this called “variable cost” or “direct labor” (meaning that if you double the number of products you are shipping then you’ll need to hire another shipping guy, so the cost is variable depending on how many products you are shipping each month). This gets a little squishy with some business models — for example with a Software-as-a-Service (SAAS) business there is no manufacturing costs but you probably want to put the cost of running the servers upon which your SAAS platform is delivered to customers.
SG&A (Sales, General, and Administrative)
This is what most people would just call “overhead”. It’s not directly variable with the number of products you are shipping — if you double the number of customers you have you wouldn’t have go hire another VP Marketing. Sometimes you will hear this called “Indirect Labor” in the sense that it’s not directly involved with making the product. So SG&A is where you put all the general overhead line items: utilities, rent, subscriptions, etc.
People are the largest expense for most ventures, so put them on a separate tab. Put the anticipated salary for each position, when you expect to add them (after year one, mid-way through year two, etc), and remember that you’ll need to put a “load” on the salary number because people cost more than their salary, after you add payroll taxes and benefits. Depending on how robust your benefits package is, people will cost you 20–40% more than their salary. Once you have all the various anticipated personnel on this tab, have the totals roll-up onto the SG&A tab (if they are indirect labor) or the Production Costs tab (if they are direct labor).
A note on CapEx vs OpEx
As you probably know, accountants talk about Capital Expenses and Operating Expenses. From an accounting perspective, CapEx and OpEx are different animals, represented on financial statements in a completely different way. But right now, for our early-stage venture, all we care about is cash. So if we buy $100,000 piece of equipment it’s cash-out-the-door just the same as paying $100,000 for a marketing campaign. So don’t worry about CapEx and depreciation tables — let the CPA worry about that later. Right now cash is just simply cash to us.
All of those things then should roll-up onto a single Summary tab that tells the whole story. The standard format is top lines that shows revenue, then Production Cost. Revenue minus Production Cost yields Gross Profit. Then list the SG&A expenses. Gross Profit minus SG&A yields Net Profit. Then list the CapEx. Net Profit minus CapEx yields Net Cash Flow. Startups typically run with negative Net Cash Flow for a while and then (hopefully) turn Cash Flow Positive, so I like to have “running cash balance” across the bottom, which will help inform how much capital you’ll need to start and scale the business.
Make sure you show the Unit Economics either on the summary tab or on a tab of its own. If you spend $100,000 on sales and marketing for the first year and expect that you’ll get 1,000 new customers in that time then your Customer Acquisition Cost (CAC) is $100. If you make $25 in gross profit per order and you expect customers to place an average of 3 orders, then your lifetime value of a customer (LTV) is $75. For most companies the CAC goes down with time, and the LTV goes up with time. And for most companies CAC is higher than LTV at the onset, but the lines should cross over at some point, and that’s the point at which your engine of growth is sustainable.
Every startup venture needs to eventually have a profitable economic engine. And once we get the “flywheel going”, that engine will create more dollars than it consumes each quarter. There will be many components to this engine, but fundamentally it all distills down to one simple equation — CAC < LTV. Every venture of every kind needs to have a sustainable process for acquiring new customers at a cost less than it can make from them.