Business Model 101

Preface

When you're a startup founder who wants to raise money, at a certain point investors are going to ask you to provide a business model. This is often after they have already familiarized themselves with the business through a pitch or presentation. The business model is typically a follow-up for investors who are already interested and now want to "kick the tires" on the business itself to get an idea of how viable it is.

To date I've raised about $10m for my business over a period of 6.5 years. I can attest from personal experience that it is significantly easier to raise significant growth capital with a functional and intelligent business model. When I was first asked to provide a business model I did what most entrepreneurs do, I contacted an accounting firm to build a business model for me. I knew I had to provide a business model, but I didn't really understand what the purpose of it was and what investors were looking for. So I paid a pretty penny to create a model that satisfied my early investors (many of whom were investing more on the strength of the idea than the fundamentals of the business).

Years later I got relatively deep into diligence with an investor group who could have invested multiples of all the capital I had raised to date. Unlike prior investors, this group sat me down and wanted to probe the assumptions of the business model. Why did I budget so much for travel (it was a place I could put some budget to justify a larger raise amount)? Why did I think revenue could grow 5x, but headcount would only grow 3x (that looks a lot better than the other way around)?

It was brutal. I answered the questions to the best of my knowledge, but the reality was that I was trying to explain a business model that was built by someone else from a template designed for a different business. I knew that we wouldn't close that investor and I resolved that I would never lose an opportunity to a shoddy business model again. So I got to work and rebuilt my business model from the ground up. It took months, not just because the business is complex and our data reporting needed work, but also because I had to learn everything I needed to know to build a very strong business model. Fortunately for you, you can find everything you need to build a great model for your business below.

The Basics

Ok so at a high level, what is a business model?

A business model is a growth hypothesis laid out in numbers.

A business model must answer the below questions, and usually in the below order.

1) What is the purpose of the business? (Make money is the most common one but this could also be "help kids" or "raise awareness")

2) How does the business achieve it's purpose? (Sell a product? Sell a service?)

3) What is required for the business to achieve it's purpose? (People, money, services?)

Essentially your model should show how you make money (revenue) and what are the costs associated with making that revenue. I like to organize my model so the costs most closely associated with earning the revenue are listed closer to the revenue. In this way if you find your business doesn't reach profitable growth you can start cutting costs from the bottom up until you reach an acceptable growth and profitability rate. In order you should show.

a. Revenue - The money you make, ideally broken down by sales unit (contract or per piece). b. Direct Costs - The costs you must incur every time you make revenue. Cost of goods is typical, or processing fees.

c. Indirect Costs - The costs you incur to operate and growth the business. Marketing, salaries, etc.

d. Profit - Your revenue minus your costs. Easy!

The precise definitions of those categories is subject to interpretation by the entrepreneur. For a business that sells primarily using Facebook ads, those ads can be considered a direct cost. For a business that sells primarily word of mouth, marketing and promotional spend could be an indirect cost.

Remember, this model represents your story about how you're going to grow your business. I don't put the labels of "direct" or "indirect" in my model so there is no opportunity for people I'm pitching to disagree with how I'm categorizing my costs.

How to deal with "I don't know" - Assumptions!

Every serious investors you're talking to knows that at the stage of your business, nothing is certain. The strength of a business model is it clearly lays out and bounds the uncertainty so your potential investors can feel confident that the business doesn't fall over in a slight breeze. The way you do this is with assumptions.

Let's say you want to raise $500k to invest in a digital marketing campaign to grow your business. You haven't run ads before so you don't know how they will perform. The NATURAL question a potential investor will ask you is

"How much revenue does $500k in ads get you?"

You must be able to answer that question with confidence. The way to do so is to lay out your assumptions on the ads. For instance.

On average every customer generates $100 of sales. (Your data)

It costs you $1 to get a click. (Industry baseline, other people's data, maybe an estimate from a digital marketing firm)

It takes 10 clicks to get someone to fill a shopping cart. (Your data)

1 out of 3 people who fill a shopping cart end up becoming a customer. (Your data)

Based on the above data, you reasonably expect that $500k of ad spend will generate more than $1.6m of revenue ((500000/(1*10*3)*100)!

Your data should be the primary resource wherever possible. Secondary would be competitors data. Then information you can find through Google. If you can't find any data or if there is none available, you can simply input your assumption, just be ready to defend it. As you get more sophisticated with your model and identify which assumptions investors ask more questions about, you can bound the assumptions with "low/medium/high" performance assumptions, and your model should show that even in the low scenario the business still does well (for instance showing your cost per click at $2/$1/$0.75).

Conclusion

So, if you have data, use the data. If you don't have data, use reasonable assumptions. The more your model reflects real data, the less you rely on assumptions, the easier your negotiations will be and the more confidence you will inspire in your potential investors.

Perhaps the best thing about building a model for your business is that it will force you to recognize what assumptions you are relying on to grow your business. Once those assumptions are clearly laid out, you can play with your model to understand which assumptions have the biggest impact on your growth. Once you know which are the most important assumptions to validate... validate them!

Each assumption represents a risk to your growth. If you can change assumptions to data and the data points to growth, you've got a home run on your hands. Even more importantly, you'll be able to show why your business is a home run in a format that potential investors digest easily.

How to use the template

Here is a template you can download to help build your own business model. To use this template you should take the following steps.

1) Fill in blue shaded cells with your information

2) Fill in yellow shades cells with your assumptions

3) Fix formulas in the model to match your assumptions

4) Double check that everything makes sense

Boom, you've got a model that illustrates your vision in dollars and cents.