Model Behavior

Abstract number sorcery won't cut it anymore. Investors want to know exactly how you're going to make money.
Magazine Contributor
6 min read

This story appears in the March 2002 issue of Entrepreneur. Subscribe »

It was just two short years ago that a profound wake-up call hit the capital markets. The numbers game of raising money had been reluctantly redefined during the 60 months that spanned from the first quarter of 1994 to the peak of the Nasdaq in first quarter of 2000. Fundamental valuations had given way to customer-driven metrics such as industry share, volume and first-to-market presence. Many on Wall Street hailed the arrival of the new "new math." Peter Henig, writing in Red Herring, said, "As long as there's dynamic growth, there are dynamic stock prices." And the recommendation that came down from Charles Crane of investment research firm Key Asset Management was, "If you believe in these new statistics, then you have to buy these stocks."

But today, huge opportunity and market share are no longer enough to secure a funding deal for your growing firm. Raising money has taken a turn back to the basics. And as company earnings have come back in line with the mainstream, the real numbers game for your deal is now focused on the most elementary component in your enterprise: your business model.

"Our initial test of any investment has to do with the validity and strength of the business model and how the management team's core experience can be used in the execution of that model," says Jeff Carmody, a bridge loan specialist with Santa Barbara, California-based Agility Capital.

"The period in time where money was raised from a flow chart drawn on a cocktail napkin has, mercifully, passed," notes Jason Spievak, vice president of business development for Callwave, a Santa Barbara, California, next-generation software-based switching technology firm. "To be taken seriously by investors today, an entrepreneur needs to have both the long-term strategic vision as well as the practical focus on operations. A real business model that can drive sustainable revenues is a must because while there's more capital than ever piled up in private equity funds, very little of it is available to the dreamer or the get-rich-quick entrepreneur."

Details, Details

Your business model describes how your business goes from preparing your product or service to delivering it to your users, and how many of those transactions you need to execute to keep up with your operating costs.

You must include these details when creating or reformulating your business model:

1. Suppliers and the average price of your company's goods

2. Labor costs per each unit your company produces

3. Selling price and the resulting gross profit margin

4. The amount your business needs to ship weekly to break even

5. Your company's annual output and the break-even point as a percentage of total capacity

A strong business model identifies who is buying your product or service and why they choose to do business with you as opposed to your competitors. It then offers a clear rationale for why buyers will pay the price you're charging (say, $50 per unit).

Once you give solid reasons for the buying decision, you need to report how many sales per day you make. If you say daily sales activity averages 250 customers (5,000 each month), then the revenue component of your model at $50 per unit is $12,500 each day. This metric has to make sense with respect to the scale and scope of your operation.

Next, you clarify your labor and materials costs in relation to your expenses. Perhaps your labor and materials costs for each sale are $28, leaving you with $22 per sale in gross profit, a 44 percent margin. If your overhead is $85,000 a month, that $22 profit margin needs to happen about 3,860 times every 30 days to break even with your fixed monthly costs. So the model now rests on whether you have the capability to do that kind of volume. If so, you have a sustainable business model where the first 3,860 customers each month cover all your costs, and the next 1,140 contribute $22 each ($25,000) to your pretax profit.

Take a look at this example of a poorly-thought-out business model: You have a "cool idea" that costs $60 in labor and materials to manufacture, and overhead runs $100,000 per month. You might believe a price of $75 will draw potential buyers, but with a $15 profit margin, you'll need to sell nearly 6,700 units every 30 days--and right now you're doing business at an average rate of less than 125 customers per day. These metrics don't work.

Or maybe you project a price of $100 (a 40 percent margin), which would drop your monthly volume point to 2,500 units. The problem is, there's no way to sustain that price-point given the competitive environment. In both these cases, the numbers don't add up, and the business model is not sustainable. There are many cases where entrepreneurs have come up with poor business models where the volume needed to cover monthly fixed costs would have to be 75 percent of the overall market share. Again, that scenario is unreasonable, and investors won't support it.

Where the Money Is

Banks and investors are anxious to provide financial backing for your company's growth. Yet they have to make the connection between the opportunity you're focused on and the details of how your model converts that opportunity into regular monthly cash flow. "When we sit down with company owners to talk about funding growth, I want to see a defined repayment source with an eventual exit strategy," says Ken Jacobsen of the Arroyo Grande, California-based corporate lending division of MidState Bank & Trust. "Your management team's experience combined with an identifiable comparative advantage offer a solid foundation upon which to make your funding pitch. But having a great business model solidifies the next crucial step of mapping out how revenues happen, where profits come into the picture, and at what level of customer-adoption the enterprise becomes profitable."

So the next time you outline a great idea for increasing your market base, take on a key strategic alliance, or augment your product-service line to broaden your customer appeal, be sure to formulate the crucial metrics that make your scheme workable. When you finally land a meeting with a potential funding source, that business model will ultimately demonstrate your credibility and expertise, and you'll significantly improve your chances of securing the funds your firm needs.

David Newton is a professor of entrepreneurial finance at Westmont College in Santa Barbara, California, and has consulted for more than 100 companies since 1982.


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