Often, these plans are written by entrepreneurs with great ideas and promising products but only a vague idea of the size of the market or how many middlemen they're going to have to cut in along the way. As a result, the sales projections that they come up with are often wildly optimistic -- $50 million the first year, $100 million the second year and $250 million the third -- and the profits are so enormous that an investor might wonder why the company needs to raise any capital at all.
And yet these entrepreneurs wonder why their business plans aren't getting funded.
The reality is that no matter how passionately you believe in your business, you've got to make the numbers work before you can turn your entrepreneurial dream into the reality of a profitable and scalable business. While nobody has a crystal ball that can predict the future, a good financial model will help you understand the key drivers that make your business tick and help you avoid the kind of problems that can sink your venture before it even launches.
Here are three common business mistakes that a good financial model can catch:
1. Your business must hit critical mass before it can reach profitability.
Any business that relies on the power of database marketing -- a time-share group, house-swapping club or online dating service, for example -- requires its database to grow to a certain size before other members will be interested in joining. And that's the catch: Until the database is large enough to attract a significant number of members, few people will want to join. Therefore, database marketers must spend big dollars to acquire customers without knowing whether their investment will ever pay off. The solution: Give channel partners (trade associations, clubs, affiliate web sites, etc.) a piece of the action in return for helping lower the cost of customer acquisition.
2. The cost of customer acquisition is too high for your company to ever become profitable.
As many dot coms discovered 10 years ago, you can't always spend your way to profitability. While laying out millions of dollars for advertising may be the quickest way to pump up revenue, it's a money-losing strategy if your company can't turn those dollars into life-time customer value. Magazine publishers, e-commerce merchants and other direct marketers may break even or lose money when they first acquire a customer but ultimately recoup their investment when the customer comes back to renew his subscription or place another order. By contrast, a company that spends $300 to acquire a subscriber who spends $20 a month and cancels his subscription at the end of the year is pouring its money down the drain. The solution: Test, measure and test again. Only when you've done enough testing to figure out how to create a positive arbitrage between how much you pay to acquire the customer and how much revenue the customer is likely to generate should you throw big money at a roll-out campaign.
3. Your company has no reseller channel.
Because it's difficult and time-consuming to acquire customers, most new companies find it easier to break into a market by tapping into a network of manufacturers' reps, agents, brokers and other third-party resellers. At my former company, NetCreations, our email marketing business skyrocketed once we were able to tap into the network of list brokers and ad agencies that recommended direct mail lists to leading magazine publishers, catalog marketers and other corporate clients. By contrast, companies like public relations firms, yoga studios and pet grooming businesses that enter a market without an existing reseller channel often struggle to survive, alternating between feast and famine. The solution: Make a list of potential channel partners before you start your business and ask them if they'd be willing to send some business your way.