You won’t be bought by Google, so Quit Fooling Yourself; you need a sound financial model!

Somehow, countless startups are still getting funded by investors without financial business models that are sound, proven, or even make sense. Even a couple of my colleagues have questionable businesses that have received infusions from angels and VCs (although, the products they’ve built seem brilliantly designed). Don’t get me wrong, I’m happy that all of these entrepreneurs are able to get funding. In some ways, it seems reminiscent of the dot-com-bomb days — lots of money flowing on interesting ideas, but no way to capitalize on them. I’m sure that many entrepreneurs say that they’ve got a well developed set of models that have been approved by their venture backers and would be crazy to share it with the public, in fear that their competition would capitalize on it. If that’s true, why does the performance of the business show no proof of one (think, YouTube, Twitter, and Yelp)? I mean, it doesn’t take a genius to see that Twitter is currently not able to generate more revenue than their implementing is actually costing them (research, design, development, graphics, legal, management, server scaling, code base refactoring, etc). Let’s be honest… everyone thinks they are going to make their fortune with each of their startups by being bought by Google or Yahoo!

For some, maybe that’s a realistic exit strategy. And for even a subset of those, perhaps that’s also a realistic revenue generator (i.e. the exit strategy IS the model). But for most entrepreneurs, this is unrealistic. You need a fallback plan, because, chances are, even if you plan your business like a perfect game of chess with the hopes of being purchased by a giant, it’s not going to work out. Even if it does, it’s likely to not be as lucrative as some of the deals that have already happened. What do we do then? We develop a financial model with realistic projections to create a cash flow that actually makes sense (uberly simplified: profit = revenue – expenses, not profit = 0 – expenses).

Before you get frightened by the idea of actually building a real business instead of one of these socially driven flukes, think about what we’re talking about here. We’re talking about building a business on a reasonably small number of investment/capital dollars, having one or more legitimate revenue streams, and eventually, a profit. As intimidating as some people think this is, it’s not rocket science (and it surprises me how many people “claim ignorance” by saying “I’m just a tech person, not a business guy” in order to avoid this basic concept). Having some idea of how you’re going to make money is a vital path to success.

Here’s how you start:

  1. Find and review example financial models, including forecast and cash flow examples.
  2. Think about your market and your products.
  3. Gather details about what you think it will cost for your research, parts, labor, prototypes, and other expenses.
  4. Gather details about what you think you will charge for your products and services, or how much you will be able to monetize from other forms of revenue.
  5. Build your financial model!

Find and review example financial models.

Before you can even start to begin building your own models, you should probably look at what other people have done (or, actually consider enrolling in a business course at a university). Examples can give you a lot of great ideas, and are a quick way to get introduced to the concepts of what a financial model really is. Just keep one thing in mind: it’s your money-making recipe from a financial perspective.

Here are some examples (and a few other introductions):

Think about your market and your products.

How can you build something for the people you haven’t even yet identified? You need to figure out who you’re trying to target; who you’re trying to sell your product or service to. This can be a little difficult, but it’s best to start with what you actually know. As you grow, you may be able to use some unique strategies of discovering what your market wants (market research reports, surveys, email questionnaires, and contests come to mind quickly).

Once you know what your market wants, you can consider what is consumable. Blindly building products that you think your community is demanding might not be the best idea. Keep yourself in it, because a large piece of your product is actually you (you can really mean the spirit of your company, morals, or views). Stay true to your vision, but don’t ignore what the reality of the market is telling you. Selling out to the demand may actually destroy the foundation you spent so long to build. Think about how to make money while delivering a product that is able to drive your client base wild.

Gather details about what you think it will cost for your research, parts, labor, prototypes, and other expenses.

In the beginning, you’re going to wing this one. But, you need to be conservative, and as thorough as possible. Ask what consultants are charging for research or labor activities. Look on the job boards to get an idea of what a full time employee will cost. There are too many questions to ask and consider, and they will be unique to your particular business. How many different components do you need for your device? What are the price points for various tiers of bulk purchasing of one component? How much time and labor do you expect you’ll need for your first prototype? What will it cost to form the business legally? How many administrators will I need on launch day? How many will grow over 3, 6, and 12 months? How about 3 years?

Write these out in the form of a FAQ or research paper if you’d like. But at a minimum, write it out in written language. This will make it easy to translate to attributes/variables in a financial model, but will provide the train of thought you had when you first sat down to put it all together. Trust me, you’ll find it valuable when you’re trying to figure out what “%vol / num. visitors” really meant, and how it was related to your project.

Gather details about what you think you will charge for your products and services, or how much you will be able to monetize from other forms of revenue.

This is the meat and potatoes of your financial model. Think of it as the framework of how you’ll make money with your business, but not the blueprint or implementation of it. For some, this is really challenging. For a born-to-be-an-entrepreneur, this might come very naturally (after all, you had a lot of experience with that lemonade stand; don’t lie, I had one too).

Ethan Zuckerman posted recently with a really useful enumeration of some of the ways you can make money. He focuses on the news industry (specifically journalism), but I think a lot of it applies to other industries too. He goes beyond the traditional ‘advertising’ and ‘premium services’ models too. This is a valuable way to get a start right now.

Build your financial model!</h3

No better time than to start building it right now. This really should be one of the first things you think about when you start evaluating your genius ideas. But don’t worry, this thing needs to evolve. It will change over a conversation with a colleague, and most definitely change over a time period of 6-12 months. And that’s good, so don’t get too stressed out if you think it’ll be too time consuming to do it all in one sitting. Get the basics down. Try to quickly prove that your idea will actually make a positive balance!

And if you already have an established business, building a real financial model for the first time can be extremely revealing! It can quickly show you what your real future holds (perhaps not as aggressive as you thought), and give you some ideas on how to refine your business so that you can actually target making progress towards that goal of early retirement.

If you’re in the sharing mood and would like to help other entrepreneurs develop their models, please feel free to link us to your model (or perhaps a model-in-progress) in a comment on this article and tell us what has really worked for you.

6 thoughts on “You won’t be bought by Google, so Quit Fooling Yourself; you need a sound financial model!

  1. This is a good guide for the people wanting to build their businesses. People are just thinking of short term gains and don’t plan their financial model well. This hurts them in the long term. The article has eye opening information on what not to do and what needs to be done.
    I am very impressed with the way it has given step by step instructions on what should be done to develop a strong financial model.

  2. kpellegr says:

    Great article and very true. In fact, there is a great book on why we unconciously convince ourselves that we *will* get the lucky break and or business will not fail.
    “Your money and your brain” by Jason Zweig discusses the various reasons why people are always convinced that their stock will go up and that they will be bought by Google… 😉

  3. A very informative article. It is surprisingly true that today’s popular IT ventures are based solely on promoting some new idea rather than building a healthy revenue model. While the traditional business-men think of creating personal wealth through sustainable revenues, the new-age IT related promoters actually believe that they can find a bigger fool to buy their business void of any revenue and create personal wealth in the process. It is called a “bubble” when the fact that you can sell it off later at a higher price is a solely sufficient reason to buy something instead of its inherent value.

    The web-based businesses, even the ones with a fairly decent revenue model need to be careful with their financial projections because IT industry has literally no entry barriers. Anyone with a decent novel idea can get loaded with Dollars from some Venture capital firm and become a serious competitor almost overnight. The assumption of steady market-share or growing market-share needs to be taken with a pinch of salt while evaluating IT financial proposals. The maturity of the financial model builder can be seen from the realistic nature of the assumptions.

Leave a Reply

Your email address will not be published. Required fields are marked *