In this section, I will cover how to build a very quick and simple financial model that will help you
to analyze if your business model will be profitable.
Most of the work that you have done in the previous sections come together in the financial model.
You should at this point have a clear understanding of your customer and the real demand for your product
or service.
And hopefully you will have completed a few small experiments with real customers and have a better
understanding of the potential minimum viable product for the market sizing exercise.
I asked you to consider the price and the quantities that you think you can sell.
That exercise should give you a clear picture about the potential scalability of your product or service.
And lastly, there is the business model that provides insight into various activities that you will
have to complete and their interdependencies to serve your customer at this point.
You essentially have a qualitative model.
Now remember its switchboard function and at one change may affect the others.
We now want to translate the activities into a quantitative model to best understand the interdependencies
and ultimately find out if our business will make money.
So we need to find a corresponding costs or revenue elements and convert them into a financial model.
And like I said, you already have many of the pieces.
For example, the customer segment, part of the business model canvas relates to the market size in
terms of the number of customers.
So putting it all into a financial model will allow us to achieve two things.
One, figure out if your proposed business model is profitable.
And second, figure out which business model is the most profitable.
As you will remember from the previous sections, changing one element would change the business model.
So you need to find out which revenue stream and which activities you should or should not do.
I will not cover how to put together a financial model.
I think there are many, many good courses available to you to show you.
I will show you a very simplified profit and loss statement.
But please remember, each business is unique and thus the model will change.
But I do want you to take away our so-called red flags or the intuition behind the numbers in the financial
model.
Now, for those of you who are less versed in financial methods, please don't worry.
As we move forward, I will explain the concepts and show you how to derive them and then also explain
to intuition behind them.
So let's go.
You first need to understand that costs are divided into two categories.
The first is direct costs, basically defined as any cost involved in the making of a product.
If you take the example of this clicker right here, the direct costs are all the cost involved in making
it so all the parts required, the labor required to put it together and potentially also the logistics
to get it to the store.
You can also have the indirect costs, which you can broadly defined as the costs involved to run the
business so as to rent research and development and many others to simplified the direct costs are again
about the product.
The indirect costs are about your business.
For this part, I would like you to ignore the business aspect and purely look at the product or the
service that you are providing through the product.
If you can't make money on purely the production of the product or service, then there's no point in
starting in the first place.
There are essentially three steps that we will work on next, which will allow you then to judge the
viability of your product.
I will explain each step in the next slides and also where you can get the information from.
This is a top of any profit and loss statement.
It basically shows the total revenue that you estimate that you can achieve over a period of time.
Now, usually investors want to see at least a five year period.
In this example, I'm applying a seven year period.
And for harder products, this is probably the best length of period, but it can be even longer if
you're working on, for example, a breakthrough technology now for digital projects, you should be
able to go with a five year plan, but definitely check with the investor that you're working with.
Based on your market sizing exercise, the top part should be quite easy to fill in your list, your
predicted unit sold and then multiply them by the price that you have set.
Now that you know how much revenue you can potentially make, you need to calculate the cost involved
in producing the product or supplying the service.
And this is where direct costs come in.
In accounting terms, they are also usually referred to as the cost of goods sold.
I've listed several categories, such as logistics and parts, but depending on the business and the
product or service, these items would be different.
You can calculate them on a different tab and then linked it totals to the meantime.
Essentially, once you know the cost of goods sold, you can then subtract the total cost of goods sold
from the total revenues to get to gross profit.
Your next step is then to calculate the unit cost and the unit margin for which I provided the formula
on the slide, the unit margin, you can calculate for all the years in this example, I've only calculated
them for the years in which I have a positive gross profit.
Now, did you have your top part of a financial model?
You can start to analyze and spot red flags.
So red flags are indicators that should tell you whether or not to proceed with the credit assumptions
or to actually tweak them.
The first is a top part in terms of units sold.
So ask yourself, how realistic is this number?
You should have done this in your market sizing exercise as well.
In this example, the stories that we will likely only sell 10 units in the first year, they probably
are prototypes.
So we want quick tests with customers and getting feedback.
Even so, selling 10 means selling at least one unit on average per month.
You have to judge for yourself whether or not this is feasible, considering the sales resources on
board and the development work that your product or service still requires in year two, we scale up
to 80 per year, which would imply selling about seven units per month and so forth.
I've seen many examples of startups where they state that they can sell a couple of hundred products
in the first year with only four people in the team, a half completed product and zero sales experience.
Now, obviously, this is quite unrealistic and your investor will catch on to that very, very quickly,
thus be aware that immediately in the first line of your financial model, you may be scrutinized.
The next is also related to your market sizing.
Check how large of a market you will have attained in the final years of your financial model.
Remember a quick calculation that I gave you to roughly estimate the market share based on either the
units sold or the revenues.
See how big your shares at this point are projecting to attain 80 to 90 percent of the market in the
last year may be very unrealistic as likely other competitors went to this space.
If the market share is too low, that you may want to be more aggressive in how you actually acquire
to customers and sell more items.
Your investor may not be interested as he or she may find a strategy to slow or perhaps the market too
complex to actually gain a large market share.
Do look for comparable companies right now and see how long they have been around and what their market
shares are like.
That should give you a realistic market share target to aim for.
Profitability or in fact, loss is obviously a very big red flag, if you're not profitable in any of
the areas that you know, you will have to tweak the price, the quantity sold or the costs involved
in making the product.
But again, as you start tweaking the model, do step back from time to time and technology is still
realistic and achievable in terms of the numbers, definitely continue to validate our customers and
suppliers about the cost and also the price that consumers will actually pay.
Then comes the question, how long until you make profits?
In this example, the first two years are negative.
Depending on the product and the industry, the realistic number of negative numbers will vary.
For hardware, it's likely that the first years are negative if you work on materials or in biotech,
it's likely you will be negative for perhaps 10 years until you complete your to your clinical trials
for digital startups, those building apps and websites, it's likely that you will turn profitable
much earlier.
Similarly, identify which parts of the model you should tweak from an investor perspective, an inexperienced
investor is likely going to be impatient and they want to see the company turn positive sooner than
later.
The knowledgeable investor wouldn't know your industry and can spar with you about the speed and also
the aggressiveness that you would need to demonstrate.
Now, as your business grows and you produce more, you should be able to negotiate better rates with
suppliers and thus get favorable terms on large quantities.
This is called economies of scale.
Your numbers should reflect a downward trend, though it is totally acceptable if it increases now and
then in some years, for example, you may just need a better material or a newer material that's more
expensive.
So do identify which costs will be the biggest driver for you and manage your purchasing strategy accordingly.
Perhaps you can buy early at discounts.
The unit margin is a very important indicator.
Remember that at this point we only have covered the direct costs and are focused on the product.
This figure tells you if you are making money on the product alone before you build the whole business
around it, it really is the left side of the business model candidates.
As we only covered for direct costs, it's very important that the Yuda margin is very high at this
point as we will need to account for the cost of running our business.
Again, I want to give you quick tools analyzing tips and also the intuition behind the numbers before
you engage in your startup.
If at this point you already noticed that your unit margin is too low, then go back and work on the
price and the costing.
You want to have as much fat, so to speak, as possible.
Now, depending on the industry and the product, you can find comparables and then see how you stack
up against them for both hardware and digital startups, you want the unit margin to be as high as possible,
probably above 60 percent.
But again, this depends on the industry and the product or service that ultimately these quick financial
indicators should tell you whether you should proceed or not and also help you to identify where to
tweak your model in the next session.
We will include in a cost and then we are able to best judge if your business model is profitable and
which business model is the most profitable.