Startup Musings

I don’t have an MBA. I have never even taken an accounting class. Yet in my years as a product person I’ve had to help generate numerous financial models to help figure out whether a new products and/or services makes economic sense.   Through my mentors, I learned just enough to generate the tables and charts that would show me whether the product or service deserves to be built.

In my mind, financial modeling for a vaporware product is a framework to help the team think through these questions:

• How many units do we think we can sell in the next few years?
• What is the average sales price?
• How much does it cost to sell each unit?
• How much do we need to spend to develop and sustain this business?

The toughest question to answer is the unit projection question.  Some people pull projections out of you-know-where.   I think a little analysis goes a long way here.  I tend to do this with a top-down approach, then cross check against a bottom-up approach.

The top-down approach is a market sizing and analysis exercise:

• Use analyst reports and other sources of quantitative data (e.g. US Census) to size your target market segment.
• Take it down as necessary to accommodate constraints imposed by your technology platform.
• Come up with a percentage ramp that predicts the market penetration you will achieve over time.
• Cross check your projected market share growth against competitors (quarterly or annual reports from public companies in adjacent or comparable markets are a great resource).
• Apply the sniff test: do you think you can sell enough to make this product worth your while?

Once the top down approach passes the sniff test, you can try the bottom-up approach:

• Build up the number of units you think you can sell via each distribution channel in the plan.
• Use hard data as much as possible – for example, if you are selling through retail outlets, check your projections against sell in/sell through data for comparable products through those outlets or classes of outlets to make sure your estimates are not out of whack.

Now that you have your top down and bottom up number, compare them and see if they match.   If they don’t, figure out why.  It may be that your top-down scenario is too rosy and the channels are fundamentally not equipped to support that kind of volume. Perhaps the distribution strategy needs to be revisited.  Or it may be that your channel projections are too rosy and assume an unreasonable growth in market share.  It’s an iterative process until both approaches pass the sniff test.  At this point I would use the bottom-up estimates as a basis to calculate gross revenue projections.

Having a credible unit sales / gross revenue projection is half the battle. The other half is to figure out whether the economics of the business makes sense. This is where the value chain analysis comes in.  Lay out everybody in the product’s ecosystem, figure out who gets paid how much and by whom, tally up all the costs out of your own business and calculate the cost of sales.  At this point, you are ready to calculate the gross margin of the product based on the expected average sales price.

Lastly, let’s count all heads and operating expenses directly attributable to the new business line.   There is the upfront cost (to develop the new product or service) that skews towards R&D.  Then there is the long term cost where R&D spending goes down into maintenance mode and sales and marketing costs go up to fuel growth.

Once all this is done, it’s time to tally it all up and make a nice hockey stick picture – the net income chart.  Typically the income will go up exponentially a couple of quarters after the product or service is introduced.   If it doesn’t, figure out why.  If you can’t make the net income look reasonable, perhaps the product or service doesn’t make sense for your business after all.