Business model is the second sign of traction: Beginners guide to get business funded- Part 4
IF you are in an investible space, IF you have a great team, and IF you have achieved some product market fit, the next question is – “Can you make money?” It’s useful to think of this question more consciously only after the first 3 questions are answered, however you have to have this question at the back of your mind all the time. Confused?
Every business has to ultimately make money. However, many entrepreneurs are forced to think too early about this. Especially when an entrepreneur is unable to raise external capital, they are forced to solve to making money too early even before they have achieved product-market fit. This results in a growing orientation towards a more “custom”, service oriented model that rarely scales and ultimately the entrepreneur is not able to product-ify. This is a classic problem that I have seen many entrepreneurs face.
If you are able to raise capital, and you have a good chance if you have the team, space and product market fit right, then the business model follows next. There are many ways to measure the viability of a business model and many ways to make money from a product. It’s not something that is tightly linked with your product. It’s a pricing thing. It has an impact, but it’s also independent. In MBA-speak, there are 4 P’s - Product, Positioning, Pricing and Place (Distribution). The Product-Market fit is about getting the Product and Place right. Pricing is linked to getting the Economics right and Positioning is about getting the longer term strategy right, it has less of a role at the beginning.
The most traditional (and admittedly, the ultimate) way of measuring the success of a business model is the bottom line – net profit. In India, it’s called PAT (Profit After Tax) and in some other markets its called Net Profit. However, in entrepreneurship, net profit is not a good measure since its too early. One has to make a lot of investments in product creation, which have not been amortised over a large enough base. Hence, to understand the viability of a business model, you have to strip down the “scalable” part of the business and put the spotlight on that. Different businesses measure that in different ways. Lets take some examples:
IT Services businesses: The simplest unit that an IT service business is based on is 1 FTE (Full time engineer) or 1 person who you are billing for. If the billing rate of an average person > all the variable costs associated with a person, then the business is viable. The variable costs may take into account the costs associated with making this person do their job – for example, office costs, computer costs and any other overhead costs associated with it. If you have a decent spread between your rate and your costs, then it’s all about multiplying this unit. The more you multiply it, it will start consuming your fixed cost base, and over a period of time, your Net Profit will keep coming closer and closer to this spread. If you are at the scale of TCS with 300,000 engineers, there is very little difference between this spread and the Net Profit - mainly its tax.
The other key metric for such a business is your ability to sell efficiently. Given the competitive nature of the market and lack of differentiation, sales are difficult. One has to build relationships and cultivate a client over a period of time. Hence, the other key metric is sales productivity. So if your sales person costs $100 in fixed costs, is he / she able to sell enough to recover costs in margin over a reasonable period of time. The higher the sales efficiency, the better the business.
Hence, an early stage services business (Consulting, IT service etc.) can be measured on 2 key financial metrics:
If these 2 metrics are good but the business is not profitable overall, it may still be a good business. Now we know that services businesses are not investible from a venture perspective, but they may attract other forms of patient capital.
E-commerce companies: Now this is a debatable space, which has attracted so much ink, especially in India. And so much capital too. The key metric that these companies observe is the CLTV (Customer Life time Value) on an acquired customer and keep studying cohorts over weeks, months and years. Now, CLTV is basically customer life time value measured as “Acquisition Cost” minus “Cumulative margin made on a customer over years”. So for example, say, you are Krishna. Lets say, an E-commerce company made you do a first transaction on their site by giving you a Rs. 1,000 coupon, i.e. their acquisition cost is Rs. 1,000. If over the following years, you bought enough goods from them to pay back this Rs. 1,000 in margins, then you are a viable and profitable customer. If they can prove that most of the customers they acquire become profitable over 1-2 years, they are a viable business. The problem may be that if they are growing very fast and acquiring a lot of customers, then the cash burn may be very high in early years and at a P&L level, they will look massively unprofitable. Investors believe that E-commerce is fundamentally viable over longer term as the existing customer base becomes larger than the new customers acquired every year. I am certain these metrics are closely watched.
Classified businesses: Lets look at a job listing site. Now, this is a little tricky since the money all comes from enterprises. You sell this database to enterprises and are making subscription money. However, the source of value is the fresh resumes that are on your website. If you look at incremental margin for the business, its close to 100%. To serve every new customer, you don’t need to incur any cost. However, to get every CV, you incur a cost – acquisition cost, branding cost etc. So source of revenue is from 1 side and cost is incurred on the other side.
I am not exactly sure what the correct metrics for this business are at an early stage, but if I had to venture a guess, it would be:
Several other classified businesses in property, marriage, restaurants, and general services follow a similar trend.
Media / content businesses: There are businesses, which don’t have any underlying transactions. All the social media is like this and these are some of the most valuable companies on the planet. All these media businesses basically compete with traditional media such as TV and newspapers and the key metric for these businesses is ad spend, which is directly proportional to time a consumer spends on these properties. So some of the key metrics these businesses use at an early stage are:
These ratios can be compared with the same ratios for traditional media and one can gauge how valuable a business is. We have seen that ad dollars follow.
Retail businesses: These are businesses like hospitals, schools, shops, coffee chains and so on. They typically have a “store model” where you open certain kind of stores, in a particular format and if it works, you keep on opening more and more. Over a period of time, you get brand leverage. In early stages, there are 2 key metrics these businesses are evaluated on:
We can keep going and there are several types of businesses and no framework can cover all such businesses. One has to look at each business individually and report the right kind of metrics.
As an early stage entrepreneur, one has to first identify the right kind of metric and then present it to the investors so that a more appropriate evaluation can be done. If the investor insists only on bottom line, that’s probably not a good investor for an early stage company. Of course, ultimately, over time, all this starts reflecting in bottom line.
Positive key metrics influenced by the right business model can be a major confidence booster for investors and very likely to fetch you strong valuations.
By Rajul Garg
Rajul is Co-founder and Director of Sunstone Business School. Previously, Rajul co-founded GlobalLogic, sold for $420M in 2013 to Apax partners in the largest deal of the year in India. Rajul built the operations of GlobalLogic from ground up in India and then expanded through global acquisitions, until 2008. He also consulted with top tier venture capital firms such as Sequoia Capital and Aavishkaar, where he got exposed to the education sector. Fresh out of college, Rajul founded Pine Labs, a leader in the Indian market in credit card transactions. Rajul serves on several Boards, including publicly traded S Mobility, a leader in digital mobility. He is an active mentor to several startups, a sought after angel investor and a participant in several industry bodies such as TiE, NASSCOM, IIT Mentors and others. Rajul is a 1998 Computer Science graduate from IIT, Delhi.
This article is part of a 5 story series. Click here to read the previous parts.
This article was originally published here