The most common definition of business suggests it is the “organized effort of individuals to produce and sell, for a profit, the goods and services that satisfy society’s needs” (Pride, Hughes, & Kapoor, 2013). In a manufacturing-driven society, this definition might be valid, yet it arguably emphasizes an outward-in approach to product and service development and in doing so has potentially set a generation or more entrepreneurs off on the wrong foot. So many entrepreneurs believe that the “thing”—the product or service—they have created will “satisfy society’s needs” without giving enough thought to understanding what society needs, values, and expects. The focus on the thing poses one of the most significant long-term barriers to success for entrepreneurs.
Entrepreneurs devote too much time and energy to the perfect execution of the product or service at the outset. In fact, many entrepreneurs invest—maybe even over-invest—in the thing before they understand if there’s an actual market for the thing. Not long ago, I spoke with an entrepreneur who had an idea for a new technology product and a pool of funds to develop the product. He was searching for a developer to help get this product off the ground but had not thoroughly researched the market opportunity for what he was about to create. Moreover, he had done little more than cursory research on his target customer. His focus was on product execution, rather than customer understanding. Unfortunately, this approach is all too common with startup entrepreneurs. A good product or service—one that meets a customer's desires—will be far better than a great product or service that misses that mark.
Steve Jobs once said, “Customer’s don’t know what they want until we have shown them” (Isaacson, 2011). To Jobs’ point, when new ideas for products and services are solicited from customers, those ideas tend to mirror competitive products in the marketplace or be derivations of products or services already available (Furnham, 2000). However, this should not suggest that knowledge of the target customer and customer input is without value. In fact, one might argue that Jobs and his team developed their products based on a clear understanding of the needs, values, and expectations of their target customer. Apple’s customers, for example, have come to expect the most innovative products, of the highest quality, that enable a short learning curve, efficient use, and support the simultaneous engagement with other products (Hyungu, 2013). Apple’s focus on delivering products to that target customer, and then taking care of that customer with committed customer service, elicits profound loyalty to the company and its products.
Customers are the only thing that matter to a business. Regardless of the product or service offered, if there are no customers, there is no business. It is surprising how many entrepreneurs start their business with an idea of a product or service and a detailed plan for execution of that offering, without a clear understanding of the customer. The customer’s needs, values, and expectations are never thoroughly researched, and the thing, as developed, misses the mark with the intended audience.
All of this is not to say that the thing—the product or service—is not essential. It is. However, a product or service is only relevant in the context of the customer’s needs, values, and expectations. A product and service placed at the center of the business, particularly in today’s business environment, may work in the near term but is not sustainable. The customer must be at the center of the enterprise for a business to have long-term success.
Perhaps a more appropriate definition of a business for our current environment might be “the organized effort of individuals to satisfy society’s needs, by producing and selling goods and services, for a profit.” Changing this definition might encourage entrepreneurs to focus first on the customer, and make product execution and delivery the second step in the business development process. Putting the prospective customer first might well make all the difference between success and failure of the next entrepreneurial venture.
What do you think? Should the customer needs, values, and expectations trump sheltered product development?
Furnham, A. (2000). The Brainstorming Myth. Business Strategy Review, 11(4), 21-28.
Hyungu, K. (2013, September). To Be A True Industry Leader: Apple Inc. and Microsoft Corporation in Consumer. Leadership & Organizational Management Journal, 2013(3), 114-130.
Isaacson, W. (2011). Steve Jobs. New York, NY, USA: Simon & Schuster.
Pride, W., Hughes, R., & Kapoor, J. (2013). Business (12th ed.). Cengage Learning.
Any business that holds and manages inventory does so with the goal of selling that inventory to produce revenue for the company. The key is to maintain just enough to meet demand, but not so much as to have money tied up in inventory for a period longer than necessary. No business holding inventory desires to have more, or less, inventory than is needed to meet customer demand at any given time because failure to meet customer demand will negatively influence sales and profitability. These factors make inventory management one of the most significant challenges any business, but particularly a small business, can encounter.
Depending on the kind of business, there can be many different types of inventory. For example, manufacturers will likely have an inventory of raw materials, work-in-progress inventory, and finished goods inventory at a minimum. A retailer might have merchandise inventory, a service business might have an inventory of hours available to resell, and a magazine or online publication might have an inventory of space that could be filled with advertisements. How each business type manages its inventory may be a little different, but each has the same purpose in mind: To maximize cash flow.
Demand forecasts are an integral part of inventory management. If the business demand forecasts are incorrect, it can be a significant blow to cash flow. For example, if the business assumes the demand will be high, and the assumption is erroneous, it may have too much cash tied up in inventory assets, which in turn would restrict cash flow because the product on hand is not selling as predicted. Conversely, if the business predicts the demand will be low, and the assumption is incorrect, it may not have enough inventory to meet customer expectations, resulting in lost sales and therefore tighter cash flow.
One of the simplest ways to manage physical inventory is to measure productivity and turnover (Traster, 2007). The idea here is to determine how often during the year the business can convert its inventory assets into cash (learn more about inventory turnover and other financial ratios here). Assessing the most appropriate turnover rates is a factor of a company’s sales volume. The goal is to either turn the inventory more times over the course of the year or reduce the amount of inventory held at any given time to maximize cash availability. If money gets tight, it is smart to evaluate the slower moving inventory and determine how price adjustments might help improve sales and increase cash flow, even if the margin on the sale is lower than desired.
Another way to manage inventory levels to maximize cash is to improve supply chain processes using a just-in-time model. For example, gaining agreement from a supplier of raw goods to hold those items necessary to produce a finished product in the warehouse, but not take them into inventory until manufacturing demand requires it, means raw materials are not in stock before necessary. This is one way to hold on to cash a little longer. Another approach might be to make a process change and to delay final assembly and packaging of the product until just before a customer may need the product, thereby reducing labor costs and inventory levels until the very minute (Anderson, 2010). These are only a couple of ways that small modifications in the supply chain process might reduce inventory levels and improve cash flow.
Service businesses and publishers have a slightly different problem. In these companies, fixed inventory is available, and when it is not used in the defined period, it is revenue lost. A consulting firm or advertising agency might have calculated its available inventory of hours by assuming that every revenue-producing person should bill (to clients) an average of 95% of his or her hours per each week for the firm to be successful. Assuming a 40-hour work week and 30-minutes for lunch each day, each should bill 35.625 hours per week. If less than 35.625 hours are billed, that inventory of hours and the revenue it would have produced is lost. The firm must somehow make up that lost revenue elsewhere. Sometimes, hourly rates are increased over time to help make up the difference. But often the solution means firing those who consistently under-perform.
Publishers allocate and maintain an inventory of advertising space within a publication for a specific time. If the advertising does not sell before the publishing deadlines, the revenue is lost. To offset lost revenue, the publisher might offer deep discounts on the unsold space at the last minute to improve cash flow. The publisher might also increase the inventory availability in subsequent issues in an attempt to recoup revenue lost to unsold advertising space.
Inventory management is an art and science. It requires diligence, a reliable inventory system, and designated staff to maximize cash efficiencies. While different business types have different requirements for inventory levels, all businesses must have a keen understanding of their customer needs and market demands to forecast need. Moreover, companies must have a detailed knowledge and control of cost and production schedule to ramp up, or down, depending on the demand forecast. Striking the proper balance with inventory is vital to maximizing cash flow.
Anderson, L. (2010). Accelerating Cash Flow Through Supply-Chain Innovation. MWorld, 9(1), pp. 36-38.
Traster, T. (2007, May 14). 5 steps to get a grip on inventory. Crain’s New York Business, 23(20).
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In an earlier post, Financial Ratio Analysis and the Entrepreneur, I shared some insights on Financial Ratio Analysis and how investors and lenders may consider and use financial ratios to determine whether to invest or lend to an entrepreneur. Entrepreneurs should also understand how to use financial ratios in the regular course of business operations. Each financial ratio has a purpose, and when compared to industry benchmarks, a ratio can provide insights as to a venture’s performance as well as help set stretch goals for business improvements and growth.
The most common financial ratios used by investors and lenders include:
These ratios indicate the long-term solvency and highlight the extent long-term debt is used to support the venture. Leverage Ratios include:
- Debt-to-Equity Ratio which measures how much debt is used to run the business.
- Debt-to-Asset Ratio which measures the percentage of the company’s assets that are financed by creditors.
Learn more about Leverage Ratios and how to calculate them here.
These ratios measure the businesses ability to cover its debt and provide a high-level overview of financial health. Liquidity Ratios include:
- Current Ratio which estimates the company’s ability to generate cash to meet its short-term commitments.
- Quick Ratio which measures the ability to access cash quickly for immediate demands.
Learn more about Liquidity Ratios and how to calculate them here.
These ratios offer insights into operations and help to spot problem areas related to inventory management, cash flow, and collections. Efficiency Ratios include:
- Inventory Turn-over which examines how long it takes inventory to be sold and replaced within a year.
- Average Collection Period which looks at the average number of days it takes customers to pay for goods or services.
Learn more about Efficiency Ratios and how to calculate them here.
These ratios evaluate the financial viability of a venture and provide a measure of comparison and performance to the venture’s industry. Profitability Ratios include:
- Net Profit Margin which measures how much a company earns after taxes relative to sales.
- Operating Profit Margin which measures earnings before interest and taxes (EBIT).
- Return on Assets which provides insights on how well management is using the company’s resources.
- Return on Equity which measures how much the company is earning for each invested dollar.
Learn more about Profitability Ratios and how to calculate them here.
As I mentioned in the previous post, these are just a few of the ratios used in determining the health and viability of a given business. Together with other factors such as customer acquisition costs, these ratios provide a great set of tools for managing an entrepreneurial venture. Fully understanding these ratios and the implications on the venture will be beneficial for an entrepreneur before he or she seeks additional investment or debt financing.
Here are a few resources that might be beneficial for identifying industry comparisons for your industry:
- RMA Annual Statement Studies. Data on business for comparisons
- Almanac of Business and Financial Ratios ($)
- Financial Studies of Small Business ($ or library)
- Bank Rate Small Business Ratio Calculators
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.
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Lenders, and often investors, will calculate one or more financial ratios when reviewing an entrepreneur’s financial statements to gain a quick understanding of the health of the business before determining whether to lend or invest. Within an industry, there will be “good” and “bad” benchmarks against which the venture will be measured (Rogers, 2014). Investors and lenders will consider the particulars of a business and likely weight the importance of the ratios differently when comparing to the industry benchmarks.
Many financial ratios could be applied, but the following appears to be most common types (BDC Staff, n.d.):
Leverage Ratios. Leverage Ratios provide an indication of the long-term solvency and highlight the extent long-term debt is used to support the venture.
Liquidity Ratios. Liquidity Ratios measure the businesses ability to cover its debt and provide a high-level overview of financial health.
Efficiency Ratios. Efficiency Ratios provide insights into operations and help to spot problem areas related to inventory management, cash flow, and collections.
Profitability Ratios. Profitability Ratios evaluate the financial viability of a venture and provide a measure of comparison and performance to the venture’s industry.
There are other ratios, of course, and as mentioned before investors particularly have ratios they rely on more based on their experience and industry knowledge. For example, a recent interview with an investor uncovered a preference for knowing the Customer Acquisition Costs. Customer Acquisition Costs are not often viewed as part of a Financial Ratio Analysis, but such factors are often important measures for both investors and entrepreneurs alike.
The entrepreneur, investor, and lender can gain useful information and financial trends on a business venture when using Financial Ratio Analysis. However, it is important to note that financial ratios have little meaning without comparison (Peavler, 2017). For example, a company can compare its ratios to those average ratios of their industries, but the best and most accurate comparisons come from using benchmark companies—high performing companies within their industry. Comparisons against these companies can create and encourage stretch goals for a business.
While Financial Ratio Analysis does provide numbers for performance comparison, it does not provide causation factors (Peavler, 2017). Moreover, identifying why certain ratios that are out of line with the benchmark comparisons is critical because it provides a starting point for correcting problems and improving financial performance. Ratio analysis can have value for entrepreneurs but depending on where the venture when it is seeking funds, these ratios may or may not be helpful in securing financing.
Entrepreneurs seeking early-stage financing are more likely to encounter investors who value continual improvements in customer acquisition costs, improvements in customer engagement at the various points of contact, and repeat purchase or purchase frequency. These measures help the investor gauge the interest in the offered products and services and are often a good predictor of long-term revenue.
Conversely, established entrepreneurial ventures—those that have several years financial history—looking for ongoing financing are likely to find as much emphasis placed on financial ratios as is placed on the customer measures noted above. This particularly true with bank financing because bankers are more risk adverse and financial ratios when properly utilized, provide a more objective measure of a venture’s performance compared to its industry thereby giving bankers a greater level of comfort when lending money.
Entrepreneurs are often motivated to launch a business in part because of their interest and expertise in a specific domain area. However, many entrepreneurs may be less skilled when it comes to the business finances beyond the basics of revenue and expenses. As an entrepreneur’s business grows, understanding key aspects of finance becomes increasingly more important, particularly should he or she seek outside investment or financing. It is important to understand the basics of Financial Ratio Analysis and how it can be used to determine the health of a business before seeking investment or financing. Yet it is equally important to understand that Financial Ratio Analysis is only one tool in an investor or lender’s tool-box. And while it is an important tool, it is not the only tool that might be used, particularly by investors, when determining the probability of long-term success of an entrepreneurial venture.
BDC Staff. (n.d.). 4 Ways to Assess Your Business Performance Using Financial Ratios. (Business Development Bank Canada) Retrieved September 29, 2017, from bdc.ca: https://www.bdc.ca/en/articles-tools/money-finance/manage-finances/pages/financial-ratios-4-ways-assess-business.aspx
Peavler, R. (2017, February 28). Limitations of Ratio Analysis. Retrieved September 30, 2017, from thebalance.com: https://www.thebalance.com/limitations-of-financial-ratio-analysis-393236
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.
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Entrepreneurs often look to friends, family, their bank account, and even credit cards when funding a startup, but many perhaps overlook this startup funding option: The strategic alliance.
A strategic alliance is a cooperative arrangement between two or more businesses for the mutual benefit all involved businesses. The idea is that each involved entrepreneur or business entity brings something to the alliance which enables a greater opportunity for near-term successes for all parties than the parties might achieve individually. While it is possible one company might invest in another to gain access to products and services more quickly that it might develop the same for itself, the more likely scenario is one in which two companies with complementary services align to improve long-term revenue generation opportunities.
For example, one entrepreneur with design experience might align with another entrepreneur with software coding experience to form a structured partnership to pitch new software projects to a prospective client or develop a software-as-a-service (SaaS) application to offer to a broader customer base.
Another example might be a larger company that needs support products or the services provided by a startup and agrees to partner to gain access to that startup’s offering. More specifically, a mapping software company may find it has difficulty selling its software for certain business applications. It could partner with a business consultant who understands how to apply business thinking to the software tools to help a prospective customer better understand the software’s value. When a sale occurs, the consultant helps implement the software and train the client.
There are challenges to strategic alliances, of course, particularly among startup ventures. The biggest obstacles appear to be a difficulty in finding suitable cooperating partners, an inability to assess the upside and downside of the alliance accurately, the challenge of properly structuring the arrangement, and the fear that cooperation might result in an expropriation of business (Hsu, 2007). Moreover, some alliances can pose a challenge to future investment funding if investors have a conflict with one or more of the alliance partners, or if cash flow rights to alliance partners dilute the opportunity for investors (Ozmel, Robinson, & Stuart, 2012). However, if entrepreneurs are open to such alliances, these obstacles can easily be overcome with the support of experienced business mentors, attorneys, and accountants.
Simple strategic alliances might occur with a “memo of understanding” that outlines what each party in the alliance will bring to the table, while a more complicated partnership might involve a formal agreement which holds each involved party accountable for providing the products and services to be delivered jointly to a customer. The most complex alliance might require the formation of a joint entity such as a corporation or limited liability company where all parties have ownership relative to their level of responsibility and risk in the alliance. The structure chosen is dependent on the products and services offered, the desired outcome of the collaboration, and the level of tolerance for risk by the parties involved.
While strategic alliances do provide an option for funding a startup or small business, it is important to remember that most strategic alliances do not usually result in a direct investment for an entrepreneur’s business. Instead, the alliance should enable an entrepreneur to secure his or her first projects or to create the initial products necessary to launch or grow a business. As a source of funding, the goal of a strategic alliance is to facilitate new opportunities, to improve the probability of cash flow, or in the case of a startup, to get a business off the ground. Finding and aligning with the strategic partner might be the first step to securing the funding needed for long-term success.
Hsu, D. (2007). Venture Capitalists and Cooperative Start-up Commercialization Strategy. Management Science, 52(2), 204-219.
Ozmel, U., Robinson, D., & Stuart, T. (2012). Strategic alliances, venture capital, and exit decisions in early-stage high-tech firms. Journal of Financial Economics, 107(3), 655-670. doi:10.1016/j.fineco.2012.09.009
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The following is an interview with Gregg Smith, Founder, Evolution Corporate Advisors, for my Advanced Entrepreneurial Finance graduate course. Gregg and I have known each other since about 2010. We discuss entrepreneurial investment from an investor’s perspective
Q. Tell me little about yourself and Evolution Corporate Advisors as it may relate to or support the financing of entrepreneurial ventures and small businesses.
A. I spent ~20 years on Wall Street as an investment banker, with most of my career spent helping growth stage companies execute private placements. I have completed over 120 private placement transactions for clients in the healthcare, technology, consumer & retail, energy and other sectors. I have also (conservatively) reviewed more than 1,000 business plans and met with 100s of management teams and entrepreneurs. I have seen many success stories of small companies I financed that were sold for >$10 billion, and many I financed that failed.
Q. When considering an investment, which is more valuable to an investor, experience in an industry vs. experience as an entrepreneur? Why?
A. Many outsiders have come to existing, “old world” antiquated industries and completely disrupted the norm—all with no prior in-depth industry experience. I would rather back a highly successful entrepreneur who has succeed elsewhere in a new industry, than back an industry insider who does not have any meaningful record of success. Also, many outsiders have a fresh perspective on things that don’t live with every day and may innovate and/or solve a problem that is not obvious to the industry insider.
Q. In your experience, which is more important in early state financing, the fit with the entrepreneur, the apparent accuracy of the pro forma assumptions, or the expected potential of the business? Why?
A. In the more than 120 transactions I completed, I have only had one client meet their first quarter projections after closing a deal. Things are very difficult to predict, and everything in life ends up costing more and taking more time than one anticipates. The same holds true with even the most sophisticated management teams using their best judgment to project where their business will be in one-quarter or one year. It is hard. I am more interested in understanding the drivers of a business and the assumptions used to project where growth will come from and anticipated costs. With this being said, for someone that is backing an early stage business, the “fit” with the entrepreneur is paramount. You will live and die at the hand of this individual, and you must understand their strengths and weaknesses. If you have confidence in the leader, then it is easier to understand the potential of the business and how and if it will be achieved.
Q. What are the top three things you look for when considering an investment partnership with an entrepreneur? Why are these three things the most important to you?
A. When evaluating a new [early stage] investment opportunity I first look at the business. Does it excite me? Will it disrupt the norm? Can it scale and scale fast? What are the barriers to entry? Next, I look at the individual and the team. Is this a team that can do it and have they had previous “wins”? Do I have confidence in them and do I want to be partners with these folks—thru good and bad? Lastly, I look at what is required to execute the plan in terms of resources and funding requirements and what is my potential exit for this investment. If invest today, what expectation should I have and how am I going to exit this investment and get a return on my capital? Will it be an IPO or a sale to another company?
Q. How important is a formalized business plan for a venture when considering an investment? What are those things you look for in a plan?
A. Formal “business plans” were popular until sometime within the last ten years. In the 1990s, I got long business plans sent to me almost daily that were mostly comprised of pages and pages of text and some financial statements. Today, most of what you see is a “deck,” some type of PowerPoint presentation on the company and opportunity that tells you everything you want to know in a more graphically, storytelling manner. Ultimately, I like seeing a deck and a working “model,” which would be an Excel file with quarterly projections and use of funds and, most importantly, assumptions that I can change and toggle if I want to evaluate my own assumptions.
Q. What are the three most important financial measures (statements, ratios, etc.) when reviewing a pro forma or a later stage investment?
A. This depends on the business. A retailer or manufacturer of a consumer product will have different metrics to review and understand than a biotech company. As it pertains to a financing, there is always risk involved when investing in a company and an investor always seeks to minimize the risks they take. Hence, I want always to understand “How far will this capital last the company?” when I am investing, and I want to try to reduce my “financing risk.” If a company tells me they need $2MM to execute their plan and get to a meaningful milestone, I don’t want to invest if they can only raise $1MM, because this would leave me exposed that they may not be able to raise the next $1MM to meet such critical milestone.
Q. How often would you, for example, use ratios to identify potential problem areas in a venture’s performance when compared to an industry sector? Which ratios are most important and why?
A. The most relevant ratios or measures I may look at today would include “customer acquisition cost” and gross margins and cost of goods. I want to understand how profitable a business is before you add in their overhead and as it relates to many online or product or service companies, how much are they spending to acquire a customer.
Q. How might seed investment requirements of an entrepreneurial venture differ from early-stage or late-stage requirements?
A. When investing in a company at the “seed stage” or start-up stage, there is a lot of risk because the company’s model may not have been proven out. In fact, a seed stage company may not even have a demonstrable product, customers or working prototype or website. In contrast, an “early stage” investment should have at least proof of concept or a working model as well as customers and customer references.
Q. What advice would you offer an entrepreneur seeking start-up or early-stage financing?
A. Finding money is almost as much about finding a partner that believes in you and your business, so there has to be some chemistry between the investor and entrepreneur. Try to find an investor that will also help accelerate the growth of the business in other ways than just providing money. Develop a pitch deck that clearly outlines what product or service you are offering, [for example] why it is better than existing solutions on the market today, how you will generate revenue and your growth strategy, why you are the strong candidate to lead this venture, how much capital you need (to do what with?), and how long it will last you till you hit milestones that will increase your valuation and lead you to raise more capital.
A conversation with an investor this week brought out that Customer Acquisition Cost is a key to his investment decision-making process. It occurred to me that many new entrepreneurs may not consider how important such a metric is for their venture, whether or not they are seeking investment. Customer Acquisition Cost is not just a measure to determine the average cost to acquire a customer; it is also used to determine the overall health of the business, the marketing budget, and the effectiveness of marketing and sales programs. For an investor, it will demonstrate the short- and long-term viability of the venture.
Let’s examine Customer Acquisition Cost in a little more detail.
CUSTOMER ACQUISITION COST
Calculating the customer acquisition cost (CAC) is not difficult. Start by totaling all of the marketing and sales costs for a period, and then divide those costs by the number of new customers acquired for the same period. Easy enough, right? Except that many entrepreneur’s—myself included—may miss costs in the calculation and do not get an accurate number against which to measure the customer acquired.
For a more detailed analysis of CAC, I think about spend and acquisition by channel. For example, in the chart below, I list the number of channels and further categorize them in measurable and non-measurable buckets. Measurable channels are those from which a customer’s purchase is trackable to the marketing or sales campaign, either through a link, a promo code, a special call-in number, or a sales order tied directly to a salesperson.
Non-measurable channels are channels which do not provide for an easily trackable source for a specific sale but are likely to contribute in some way to sales in general and should be calculated as part of the overall CAC. Brand campaigns might fall into this category, as would most promotional activities such as an entrepreneur’s speaking engagements, and networking events, to name a few. By adding the costs together and then dividing by the number of customers acquired for the period we arrive at an Average Customer Acquisition Cost.
One of the advantages to tracking spend and acquisition by a channel is the ability to determine which channel is most effective in generating customers. If, as in the example above, Inbound CAC is lower than PPC CAC, one might look more closely at the PPC campaigns to determine how and where improvements may need to be made if it appears those costs are out of line with expectations. But, how to do we determine what is reasonable? We need to calculate the lifetime value of a customer.
CUSTOMER LIFETIME VALUE
The Customer Lifetime Value (CLV) helps us determine the value of a customer over time. This helps us determine how much we can spend to acquire a new customer, and how much we could spend to retain that customer. The CLV estimate considers several key things: The average order value, the average number of purchases, and the average customer lifespan. The customer retention rate, average margin per customer, and a “discount rate” which adjusts the future profits from the campaign for the uncertainty of performance vs. investing instead in other business operations.
In the chart below, we estimate that a customer will have three purchases per year with an average order size of $35. We anticipate that the average customer lifespan is three years and we will have a 75% customer retention rate. Based on the particular product we have an average of 70% profit margin per customer. The discount rate in the example chart below is set to 10%; however, the longer future customer revenue is expected, the higher the discount should be to factor the greater possibility of inaccuracy.
We use three different LTV calculations in the chart above: A simple LTV which calculates the sales over the customer’s lifespan, a more customized LTV based on the average gross margin on sales over the customers lifetime, and the more traditional LTV calculation which incorporates the discount rate. Then we average the three methods to arrive at an Average Customer LTV. Using the data in the above chart, the Average customer has a value of $316 over his or her lifespan.
Now that we know our Customer Acquisition Cost and Customer Lifetime Value, we can determine whether our cost of acquiring a customer is reasonable given our assumptions, or if we’re using actual numbers, whether we may be over-spending or under-spending to gain a customer.
CUSTOMER ACQUISITION SUMMARY
Our CAC calculations indicate the average cost of acquiring a customer is $100.00. Our CLV calculations suggest that the average customer spends $105 per year. For most business types, an entrepreneur would want to limit the cost to acquire a new customer to approximately 30% of what an average customer spends in a year. Considering that the customer spends $105 per year, the target expenditure to acquire a new customer should approximate $35.00 as shown in the chart below.
The numbers used in this scenario suggest overspending on customer acquisition by about 186% more than necessary.
As a result of the overspending, the average customer is unprofitable the first year and reduces the overall profitability during his or her lifespan assuming the customer is retained as shown in the next chart. If the customer is not retained, the loss would be much greater.
In the scenario outlined here, the cost of acquisition is much too high and the possibility to recoup the investment over time is suspect. These factors would likely be a red flag for an investor.
Remember, Customer Acquisition Cost and Customer Lifetime Value will vary from venture to venture and industry to industry. Benchmarks are difficult to find, but using models such as these, a baseline can be established from which to work forward. As with all financial analysis, each entrepreneur should develop his or her own CAC and CLV models so that the specifics of the business are incorporated. To assist, I have attached the spreadsheet model to download and explore below.
Understanding the Customer Acquisition Cost is critical to business operations. Every entrepreneur should know what it costs to acquire a new customer and how those costs flow through the business in particular to the impact on marketing budgets, the effectiveness of marketing and sales expenditures, and overall business profitability. Spending too little for customer acquisition will result in missed opportunities, but spending too much will decrease profitability. Keeping track of Customer Acquisition Costs is a good first step in ensuring profitability, and it will likely play a role in a prospective investor’s decision-making process.
A few notes on this model:
- This model is an example and is for use as is. It is not supported in any way. It is not intended to be a tool to use without customization based on the specifics of an entrepreneurial venture.
- This model is only an example to give the reader an idea of how such a tool can be developed. It is not based on a real business. I compiled this model for a graduate class, but I have developed similar models for entrepreneurial ventures. Each business venture is different, and so is the CAC and CLV that are prepared for that venture.
- Most CAC and CLV calculations are done annually using actual numbers. This model can be used in that way. It can also be used for estimating and creating variations in the start-up phase of a venture. In the later situation, “what if” scenarios might be deployed to determine the outcome of different of customer acquisition costs or levels of lifetime value.
- This model is set up for annualized numbers; however, one could create a similar model with monthly numbers to track improvements over time.
- All of the “Bold Blue” text areas can be changed to demonstrate how the interactivity might work. No other data can be changed.
- Formulas can be seen in each of the cells (mouse over it), but only the values in the “Bold Blue” text area can be changed.
- By downloading you acknowledge this is for personal use only. It is not to be sold or distributed in any way.
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Startup entrepreneurs face a daunting challenge in forecasting cash flow, profitability, and return on investment. It can be so overwhelming that many just ignore the numbers and jump right into developing a product or service. Certainly, a refined product or service is a critical early step in launching the entrepreneurial venture; however, understanding the financial aspects of the business, including the inputs to the product or service development is paramount to forecasting cash flow and business profitability, is equally important.
In business, particularly in the start-up phase, “pro forma” financial statements provide a way for the entrepreneur and potential investors to see the financial forecast of a business given a set of assumptions. The pro forma financials will include a set of assumptions on which the numbers were based, a cash flow statement, an income statement, and a balance sheet statement. Together, these statements provide an approximation of business performance considering the assumptions. Most investors place little value on the numbers a start-up provides because the core assumptions may be inaccurate (Rogers, 2014). And if the assumptions are inaccurate, the financial performance will change. One of the best ways to understand how assumptions change the financial performance of a business is to build an interactive pro forma.
The interactive pro forma will allow an entrepreneur to quickly change assumptions and easily see the possible financial impact on the business as those assumption flow through the other financial statements. Once set up, it allows an entrepreneur to play a “What-if” game with assumption inputs and watch how those changes affect the business performance. The interactive pro forma is also a great tool to use when seeking outside investment. If the assumptions are challenged by an investor, they can be modified in real-time, and those modifications flow out to the other statements. This provides an instant view of the new business financials once new assumptions are in place.
Spreadsheet tools make building an interactive pro forma easy, although it does take some knowledge of the tools and a few hours to set up the models. Most of the time spent should be given to considering the assumptions. Assumptions are the most important part of the model and where entrepreneurs should put the bulk of their time.
Here’s one way to build an interactive pro forma:
- In a spreadsheet program, create a new workbook with four tabs. Label each tab as follows: Assumptions, Cash Flow Statement, Income Statement, and Balance Sheet.
- On the Assumptions Tab, list all of your assumptions about the business. Depending on the business one might choose product pricing, sales figures, monthly costs of operation, depreciation, taxes, insurance, etc. Make sure everything that could affect the business costs or revenue structure is included.
- On the Cash Flow Statement tab, include the beginning cash balances, your sources of cash, and the uses of cash for each month. Use the assumptions to drive the revenue (sources) and expenses (expenses) on this tab. Note that the cash that’s left over at the end of each month becomes the Beginning cash balance for the following month. The Cash Flow Statement shows how the business will use the money it receives each month.
- The Income Statement tab pulls data from the Cash Flow Statement tab but formats it differently. The Income Statement in a pro forma shows whether the business is profitable for a period by looking at the revenue and expenses based on the original assumptions (and cash flow).
- The Balance Sheet pulls data from the Cash Flow Statement and the Income Statement to provide a look at the assets, liabilities, and equity of a company at a point of time. It helps the entrepreneur better understand what the company owes (liabilities), what it owns (assets), and the equity held by shareholders.
The above points are over-simplified. The idea is to give an overview of the process. Each entrepreneur should develop his or her own pro forma to understand the specifics of his or her business better.
This said I have provided an example interactive pro forma workbook for an online publishing business for readers to download and explore. Some may have the skills and abilities to create a similar model, but others may need the help of a financial professional.
Using an interactive pro forma will help an entrepreneur get a better handle on his or her business by allowing the exploration of What-If scenarios what might impact the business. It is much better to explore these scenarios in advance of launch and develop contingency plans than it is to encounter the problems in “real time” without possible solutions waiting.
A few notes on this model:
- This is an example for use as is. It is not supported in any way. It is not intended to be a tool to use without customization based on the specifics of an entrepreneurial venture.
- This interactive pro forma is only an example to give the reader an idea of how such a tool can be developed. It is not based on a real business. I compiled this model for a graduate class, but I have developed similar models for entrepreneurial ventures. Each business venture is different, and so is the pro forma that is prepared for that venture.
- On the Pricing Assumptions tab, all of the “Bold Blue” text areas can be changed to demonstrate how the interactivity might work. No other data can be changed.
- The best way to explore this model is to look at the other statements before changing anything, then change one thing and see what effect it has on the model.
- In this workbook, I have included an additional tab to for calculations of revenue and expenses based on the pricing assumptions. This worked easier for me to build the calculations, but others might do it differently.
- Formulas can be seen in each of the cells (mouse over it), but only the values in the “Bold Blue” text area can be changed.
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur (3rd ed.). New York: McGraw-Hill Education.
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