Weekly Accelerator Updates

Week 7: Finance and Operations

Week 6 Recap: Modeling Revenue

In Week 6 we covered a lot of ground, including the following topics:

  • Revenue as the best source of cash – and cash is king
  • Different revenue models including transactional, subscription, usage based and more (and why ad-based revenue streams don’t typically pay dividends until you have tens of millions of visitors to your site)
  • “Unit economics” and the importance of defining the right “unit” – because that is how you sell and how you can model revenue
  • LTV and CAC: How Customer Life time value (LTV) and Customer Acquisition Cost (CAC) change over time 
  • Pricing strategy & Price Testing: Understanding how to set prices and how to test pricing and purchase intent 

Week 7 focus: Finance and Operations

This week, we are going deeper into the world of entrepreneurial finance. If you are new to the world of finance, start by watching the following short videos from the Kaufman Foundation.

The Income Statement, A.K.A. the Profit and Loss Statement (P&L)

Now we are ready to dive into Finance and Operations with the Income Statement, also called the Profit and Loss Statement (P&L).

The P&L is one of three financial statements that companies use to operate their business (the other two being the Cash Flow Statement and the Balance Sheet). Boiled down to its essence, the P&L basically communicates the following things.

  • Money you make (revenue)
  • Minus money you spend (expenses)
  • Minus things like taxes, depreciation of capital equipment, etc.
  • Equals money you keep or lose (bottom line

The pro-forma P&L as a tool for strategic decision making

Entrepreneurs building new ventures frequently find themselves creating a 5-year projection of your income statement or P&L. This is called a “pro-forma“. The purpose of the pro-forma is for the entrepreneur to clearly think through their assumptions about their business.

A 5-year pro-forma P&L for a new business is guarantied to be a work of fiction. So why do we still encourage entrepreneurs to create one?

The reason is that putting your core assumptions down on paper forces you to do a bottom-up thought experiment to think through how you manage your business activities to achieve your revenue projections – and what it takes from a people and budget standpoint to get it done. The accuracy is not the point. The structural thinking is the actual value.

The pro-forma P&L as a sneak preview for your business 

Creating a pro-forma also helps the entrepreneur get a sneak preview on what kind of business they are building. Here are two common patterns that reveal themselves once you have some fun with spreadsheets. 

  • B2C – low value, high volume, short lead time: A B2C business charging a low price per consumer (e.g. <$100 per year) will find it easy to start and can start generating revenue very early, but getting to a $100,000 per year revenue will require large numbers of consumers in their install base that can be expensive to acquire. 
  • B2B – High value, low volume, long lead time: A B2B business charging a large amount to enterprise customers (e.g. >$50,000 per year) will have long sales cycles, so the first couple of years might be characterized by much smaller pilot deployments – and they need to hire sales folks a year or more before the new sales force can close deals and generate revenue.

The pro-forma P&L as a sniff test for “investability” 

One last benefit is that you will see the scale, scope and rate of growth of your business at a glance from the rate of revenue growth. This is tremendously helpful for many for-profit businesses, because investors want numbers. 

  • 8 years ago, Techcrunch posted an article in which they examined 5 public SaaS companies’ “path to $100M” in their early lives (all of them achieved it in about 5 years).
  • 3 years ago, Shasta Ventures posted an article where they shared what it takes to raise an A round in Annual Recurring Revenue (ARR) and growth rate.

Being able to forecast the scale, scope and projected growth rate of your business will tell you whether your business checks all the boxes to appear “investable”.

  • If so, it will give you what you need to raise money.
  • If not, it can be used as a tool to iterate your business to get to cash-flow-even.

Entrepreneurial Operations: Legal considerations 

For new ventures, understanding how to run their business means understanding legal implications.

Legal considerations include but are not limited to the following:

  • Company formation: C-corp, S-corp, B-corp, LLC, or 501(c)(3)
  • Intellectual property (IP) protection: Patents, trademarks, copyright, trade secret?
  • “Capitalization Tables”: Who owns how much of the company 
  • … etc

Watch Professor Joe Volman’s workshop on Entrepreneurial Business Law to learn more.

Entrepreneurial Operations: Back-office Systems and Processes

Systems and Processes refer to the infrastructure that allows your company to operate effectively. When you are just starting out, the processes that tend to help include:

  • RACI models – clarity around roles and responsibilities
  • Accountability rituals – things like daily scrums, sprint planning and retrospectives help keep the team on task
  • Communications platforms – agree on when and how you communicate on which platforms, synchronously and asynchronously
  • Task management platforms – use something like Trello, Asana or make your own Kanban board to manage work and share status
  • Accounting platform – this is the financial backbone of your company. A lot of people start with Quickbooks Online then move on to a full-fledged Enterprise Resource Planning (ERP) platform when they are mature.
  • Customer Resource Management (CRM) platform – this allows you to manage contacts, record and write notes about sales calls and the like.
  • Marketing Technology (Martech) platforms – platforms like ThriveHive or Hubspot help you keep all your online marketing activities in one place and to manage the massive amounts of data that helps you build brand and acquire customers.

Building a 5-year Pro-Forma

Let’s do a simulation so we can work through the key concepts, terms, and equations you need to understand in order to create a pro-forma P&L, starting with revenue projections. 

Imagine we are a marketing insights company (like CBInsights), and we do specific industry research in, say, the business trends for robotics and AI. We offer a subscription service to companies requiring this type of research, at a company-wide license starting at $5,000 per month, or $60,000 annual recurring revenue (ARR)per year. 

Modeling Revenue

For this business, we can model our revenue for our second year in business as follows: (you will see in a minute why we chose the second year and not the first year.)

  • Unit: In this case the unit is a company that acquires a license with our Marketing Insights company
  • ARPU (Average Price Per Unit): In this case, it is $60k per year.
  • # New customers acquired this year: Let’s say for our second year, we will sell this to 10 new customers through direct sales.
  • # Customers last year: Let’s say last year we sold to 5 customers. 
  • Churn: Churn refers to the percentage of customers who do not renew. We are so new that nobody has had time to cancel, so we have 0 Churn this year.
  • Install base: Based on the above, the “install base” is the # of customers last year plus the # of customers this year, minus churn. In order words, our install base is (5 + 10 – 0) = 25.
  • Cost of Goods Sold (COGS), a.k.a. Cost of Sales (COS): This is the cost of providing the service to the customer and includes server costs, cost of the devOps department (i.e. engineers who keep the server running so people can download reports), customer support and the like. It does not include the actual analysts’ salaries or general web development costs or marketing costs – that goes into the operation expenses section (see below). Let’s say this is $250,000.

The gross revenue in Y2 is the install base multiplied by the ARR: (25 * $60k) = $900k.

The COGS in Y2 is $250k.

The gross profit is the gross revenue minus COGS: ($900k – $250k) = $650k.

The gross margin equals the gross profit divided by the gross revenue expressed as a percentage: ($650k / $900k) = 72%.

This is the basic recipe for projecting revenue out to year 5. In year 1, churn is typically 0 and the install base is simply the “net new customers” in Y1. Moving into the out-years, churn will increase – but so will your install base because you are hopefully keeping 95% of your customers year over year (YOY). With this, you can project revenue by changing the number of new customer acquisitions, changing ARPU, or changing projected churn. You can now easily model different scenarios to help you make business decisions every step of the way.

Modeling Operating Expenses

For this type of business, most of your operating expenses fall into the following departments:

  • Product development – this includes the analysts who conduct the research, data scientists helping them manage and visualize the data and writers who turn data insights into reports) 
  • Marketing and sales – these departments are often combined in the beginning but will usually separate into two departments over time 
  • General and Administrative – this includes finance, human resources (HR), legal and the like.

For each department, there will be a few types of expenses that dominate the spending.

  • Product Development will spend the lion’s share of their annual operating budget on headcount.
  • Marketing and Sales would have significant budget for doing direct sales, going to tradeshows and the like, in addition to their headcount expenditure. 
  • G&A will likely have significant expenses in professional services like legal expenses.

Putting it together: Revenue – Expenses = Bottom line

Once you have modeled your revenue and expenses, you are ready to put it together into the same spreadsheet which has the three sections mentioned above:

  • Money you make (revenue)
  • Minus money you spend (expenses)
  • Minus things like taxes, depreciation of capital equipment, etc.
  • Equals money you keep or lose (bottom line)

Additional Resources

Following are some resources that will help you accelerate your progress this week.