Business Modeling For Internet Startups

Part I

Pierre-Yves Pau

DRIVEN ACCELERATOR

April 4, 2013

What We Will Cover Today

• Part I of a two-session class

• Part II after the Milestones report

• A sub-report on your analytics, revenues, and costs will be required as a Milestone deliverable

• Templates covered in this presentation will be emailed in advance to that end. Feel free to modify them

• Part II will use your inputs to cover scenarios specific to your startup, and valuation projections

• Presentation will be emailed after tonight’s session

Agenda

• Overview of Business Modeling issues

• Cost classification

• Relevant costing concepts

• Customer acquisition costs

• Contribution Margin & Breakeven analysis

• Modeling techniques for long-term analysis

• R&D and deferred costs for startups

Why Business Modeling? • Internet startups are different:

– Sell intangibles: often, only product is traffic creation

– Willingness to use versus willingness to pay?

– Value is wide adoption

– Need to spend money well ahead of really making any

– HOWEVER, low capital intensity

• Manage cash until value is created through adoption

• Change the game if necessary (“pivot”)

– Groupon, PayPal, Twitter…

Instrumental in planning the “right” decisions Even “failing” should be a decision – not an accident

What is a Business Model? A critical component of your Business Plan:

• Revenue streams

• Long-Term customer Value (LTV)

• Sustainable competitive advantage (e.g., IP)

• Scalable cost structure

• Channels & affiliates compensation

• Capacity to execute

• Key Performance Indicators (KPI’s)

Which facts & rationale support these?

Service/Content provider Portal Exchange Market creator M-Commerce Meta-media Transaction broker Community provider e-Tailer/Distributor/Procurement B2B, B2C, C2C, P2P Enablers (Servers, S/W, encryption, payment systems...)

Types of Business Models

WHAT are you selling to WHOM, WHY, WHEN and HOW?

10 Startup Financial Pitfalls

Wrong Business Model or Wrong Execution

Over-optimistic forecasts Scenario planning

Cash-flow crunch Budget revenues versus expenses & liabilities

Lack of on-going planning& review Identify KPI’s

Barking at the wrong tree Data-driven analysis of the Value-Chain

Not managing debt Debt is good (leverage), too much debt is lethal

Not managing investors Financials, Milestones, Pro-activeness

Raising too little money Plan for scale & contingencies

Spending too much money Track costs, & keep them down

The CRA One tax bill can wipe you out of business

Inaccurate valuation Understand how valuation works

Financial Road-Map & Deliverables

• Characterize your addressable market

• Identify your Sales Mix & Drivers

• Define your financial objectives: ―Planning horizons ―Forecasts ―Pro-forma statements

• Model your Cost Structure & KPI’s

• Reach break-even, and raise more money...

• Or go bust and try something else!

Addressable Market

• Value-Chain

• Size

• Reach

• Channels

• Lead flow

• Conversion rates

• Monetization options/opportunities

Just because a market exists does not mean you are in a position to capture (a share of) it

Sales Mix & Drivers

Mix: ―Per user / subscriptions / metered service

―Per transaction / exchange / sale

―Percent of transaction amount (Broker)

―Per Ad-View, Page-View, Referral (Affiliate)

Drivers: ―Blogging, Event marketing, Advertising, PR

―Contextual advertising (AdWords/AdSense)

― Social Marketing, direct sales, affiliate sales…

―Discounts, channel commissions

Forecasts • Establish drivers for Cost and Revenue sides

– Some will drive both (e.g., #units of sales)

• Scaling assumptions – users / traffic / whatever…

• Relevant planning horizons: – Next Quarter, 1 year, 3 years…

• Most important: user adoption – Will need to spend money driving it up

• H/W, S/W, B/W, hosting costs will be relatively minor – At least initially, but how do they scale?

• ARPU? PageViews / AdViews? # Transactions? – Describe and forecast each potential revenue stream

Relevant Costing Concepts • Cost Pools & Cost Drivers

• Fixed vs. Variable costs

• Variable Costs *vary* with Sales

• Fixed Costs do not vary over relevant range

– “Relevant” usually means fiscal period

– But could also mean product / application life-cycle

• Contribution Margin (CM)

• Break-even analysis

• Long-term forecasting techniques (> 1 year)

• Cost capitalization & deferral rules

Costs Classification - Example Other potential costs:

• Service subscription

• Web development

• Cloud & SaaS

• Bandwidth & SLA

• API development

• Servers

• Special categories:

– Pre-operating costs

– Deferrable costs

– R&D costs

Acquisition Costs

• Pay-Per-Hit (PPH), Cost-Per-Hit (CPH)

• Conversion Rate (CR)

• Cost-Per-Acquisition (CPA)

• Revenue-Per-Hit/Acquisition (RPH, RPA)

• CPA vs. customer LTV – LTV factors-in Customer Life-Cycle, Repeat Sales, Churn

• Variable vs. Fixed component of CPA (VCPA, FCPA) – PPH = Variable => VCPA

– Marketing budget = Fixed => FCPA

If CPA > RPA, the venture will be short lived

CPA Management Guidelines • Aim for LTV > 3 x CPA

– Most public Internet companies have LTV ~5 x CAC

• CPA recovery < 12 months – If not business will require too much capital to grow

• Use widest possible range of traffic generating techniques

• Clickable advertising (e.g., AdSense) is a double-edged sword: – Add clicks are “free” revenues, but

– Adds can increase PPH costs by decreasing page Quality & Relevance

• Target all search terms (even typos)

• Test for CR, CPA

• Don't hype: you want customers, not surfers

• Work on branding - make sure everyone sees your site name

• Leverage “free” techniques (forums, articles, PR etc.)

Modeling Assumptions

• Host server, lease, or buy?

• How much spend on R&D-eligible work?

• Planning on taking the business mobile?

• Market / customer segmentation?

• Product and channel mix?

• Staff leads, affiliates, customer support?

• How far do you want to “scale” the business?

• Building a company or building an exit position?

Keep and up-to-date list of these. A VC would want to know this

Contribution Margin • Essential concept for Business Model validation

CM$ = Sales$ – Variable Costs$ • Breakeven = Sales Volume required to cover Fixed Costs, given

average CM# per transaction

#Transactions x Sales#$ = FC$ + #Transactions x VC#$ #Transactions x (Sales#$– VC#$) = FC$

Sales Revenue

VC <

FC > Total costs = FC + VC

Profit >

Transaction Volume #

Breakeven >

$

Contribution Margin – V.CPH Impact (1/2)

Determine optimal bid / Hit or Click as a function of Conversion %

Contribution Margin – V.CPH Impact (2/2)

•Hits •Page Views •Visits / Sessions •Visitors / Unique Visitors •Bounce Rate •Etc.

Web-Analytics (1/2)

Traffic patterns? Conversion rates? Profitability? Segmentation?

Web-Analytics (2/2)

1. Start gathering analytics NOW

2. Determine maximum profitable VCPA

3. Determine Conversion Rate & RPH

4. Determine maximum profitable CPH

5. Calculate CMPH, CMPA, total CM over relevant range

http://www.youtube.com/watch?v=g_w9YJeJgUw http://www.youtube.com/watch?v=jRx7AMb6rZ0

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Quarterly Break-Even Analysis (1/1)

Modeling a range of different traffic scenarios => breakeven point

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Quarterly Break-Even Analysis (2/1)

Breakeven = FC$ / CM$ per Unit = $2,000 / $5 400 units

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Contribution Margin – w Sales Mix (1/2) Quarterly View – PPH Driven Only

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Contribution Margin – w Sales Mix (2/2) Expanding Quarterly View to Yearly View

What would be the impact of adding affiliate referrals to our business model?

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Contribution Margin – w Sales Mix (1/1) Quarterly View – PPH + Affiliate Referrals

Quarterly CM improves by $2,500 due to affiliate referrals

Year1 Year2 Year3

Expanding Yearly View to Multi-Year Horizon

• FC’s are only “fixed” over a specific relevant range

• In the long-run, all costs are variable

• Problem, FC variations are discontinuous: – E.g., relocation, hiring, interest expenses from investments... – Discrete management decision – hard to accurately forecast in time

• Hence FC are “mixed” costs – Including a “fixed” and a “variable” component

Relevant Range

FC Year1

FC Year2

FC Year3

VC#, Variable Component

FC, Fixed Component

Hi

Lo

• Hi-Lo (High-Low) models mixed costs using simple linear assumption:

• LCD: Low (cost) Driver Value

• LCV: Low Cost (pool) Value

• HDV: High (cost) Driver Value

• HCV: High Cost (pool) Value

• Hi-Lo (0) = FC = Constant

• Variable Unit Cost = VC# = Slope

?

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Hi-Lo Cost Modeling

Assuming 3 employees in Year 2:

• Quarterly rent expense = $3,257 + 3 x $342.86 = $4,286

• Quarterly utilities bill = $1,071 + 3 x $214.29 = $1,714

Assuming 5,000 customers in Year 2, quarterly marketing expense = $157 + 5,000 x $0.01 = $229

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R&D Costs

• Research activities:

– Involve planned search or critical investigation aimed at discovery of new knowledge

– May or may not be directed towards a specific project

• Development activities include:

– Translation of research findings or other knowledge into a plan or design for a new product or process, or

– Significant improvement to existing product/process

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R&D Costs Challenges

• R&D costs are not in themselves intangible assets

• Often material in amount and lead to something that will be patented or copyrighted

• Challenges in R&D accounting:

1. Determining costs associated with a particular activity or project

2. Determining size of future benefits and for how long those benefits may be realized

3. Treatment of deferred costs: costs which will not be expensed until a future accounting period

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R&D Costs What can be included?

1. Materials and services consumed

2. Direct personnel costs (e.g. salaries)

3. Amortization of R&D equipment and facilities

4. Amortization of intangibles related to R&D

activities (e.g., patents)

5. Reasonable overhead allocation

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R&D Costs CICA Handbook, Section 3450

• All research costs are charged to expense when incurred

• Development costs are charged to expense except in certain defined circumstances (see next)

• As an exception to the above, may be able to capitalize if:

– A company purchases in-process R&D as part of a business combination, or

– All of five capitalization conditions are met (see next), and future benefits are reasonably certain

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R&D Costs: Cost Capitalization Criteria

1. Product/process clearly defined & costs can be identified

2. Technical feasibility has been established

3. Management’s intent is to produce and market or use the product/process

4. If: • intent is to sell, a market is clearly defined

• if the intent is to use, there is a definable use/need

5. Resources exist to complete the project

—Capitalization of Intangible assets is often a grey area

—Expensing development cost will only decrease positive taxable income

—Capitalizing development cost will help build equity => financial leverage

—Impairment of Book Value (BV) of Intangible may be required if cost not recoverable

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Deferred Costs

• A deferred cost can be a liability or expenditure

• Not recorded as a cost of operation for the period in which it was incurred

• Written off on a later date.

• Deferred costs can also be prescribed to assets that: – Cannot be reliably recognized as such – yet – but,

– Need to be deferred to be matched with future income in order to avoid a distorted net income.

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Other Deferred Charges Organization Costs:

• Costs incurred to form a corporation (e.g. underwriter fees, legal fees)

• Usually recorded as an intangible asset

• They are usually amortized over a relatively short period of time (perhaps up to 5 years)

Advertising Costs:

• No Canadian standard

• Usually expensed as difficult to measure future benefits

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Effect of Intangibles on Accounting Income

Cost of intangible

R&D

Amortized identifiable intangible assets: •Patents •Copyrights •Franchises •S/W costs •Leasehold improvements

Intangible identifiable assets reviewed for impairment: •Trademarks & names •Licenses

Unidentifiable intangible assets reviewed for impairment: •Goodwill

Expense

Recognize loss when/if impaired

In period cost is incurred

Amortize over useful life

―Capitalizing means R&D results will be marketed in the near future and may yield future economic benefits. => signal to investors

―Expensing indicates that costs incurred have no value - unless they represent R&D spending that has expected future benefits even though the criteria for capitalization have not been met => unrecognized intangible assets

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The Effect of Capitalizing R&D • Operating Income will generally increase, (depends upon

whether R&D is growing or not). If it is flat, there will be no

effect since the amortization will offset the added-back R&D.

• The faster R&D is growing the more operating income will

increase.

• Net income will increase proportionately, depending again upon

how fast R&D is growing.

• Adjusted Net Income will also have to take the tax deductibility

of R&D into account (for taxable income calculation).

• BV of equity will increase by the capitalized Research asset

• Capital expenditures will increase by the amount of R&D

• Depreciation will increase by the amortization of the R&D asset

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Intangible Asset Recoverability Test & Impairment Loss

Example: • Carry amount of patent $6,000,000 • Recoverable amount $3,500,000 • Fair value (discounted C/F’s) $2,000,000

Recoverability test? • Indicates impairment (since $3,500,00 < $6,000,000)

Impairment loss? • $6,000,000 – $2,000,000 = $4,000,000

© 2007 John Wiley & Sons Canada, Ltd

Developing the ability to quantitatively model your business will be key in determining potential for impairment

C/F: Cash-Flow

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International Comparison

• Canadian and international GAAP are substantially converged for intangible assets

• Some remaining differences related to:

– “Negative” goodwill

– Pre-operating costs

– Internally developed intangibles

– Impairment models for goodwill and other intangibles

Modeling Taxes • Tax is a cash outflow. So we should include taxes in our business modeling

• For Canadian-controlled private corporations claiming the small business

deduction, the net tax rate is 11%. Fed,10% prov.

• The Ontario small business deduction reduces Ontario basic income tax,

resulting in a lower tax rate of 4.5%

• Given cash focus, depreciation when modeling taxes is what is recognized for

tax purposes.

– In Canada, this is called Capital Cost Allowance, CCA (see CRA site for CCA classes)

• CCA is calculated as a % of the Undepreciated Capital Cost (UCC). A % amount

is deducted each year, UCC will never reach zero (for a going-concern)

• Hence CCA deductions can continue even after the project ends (and thus

shelter future income from taxes)

• All CCA-caused tax savings should be recognized as cash inflows for the project

that caused them (if multiple projects)

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Pre-Operating Costs • Costs incurred prior to start of formal operations

• Can be written-off against future revenues

• Conditions for deferral:

1. The expenditure relates directly to placing the new business in service

2. It would not have been incurred if not for the new business

3. The amount is likely to be recovered from future operations of the new business

• Amortized over a maximum of 5 years

Summary and Conclusions • Business modeling provides:

– A framework for validating your business plan

– Deep insight on the determinants of profitability and growth

– A roadmap for managing cash-burn to Round A financing

– Supporting figures for valuation hence negotiate financing / funding

• This presentation covered:

– The rationale for business modeling

– Examples of Internet Startup business model validation using CM

– An overview of the sales/traffic and accounting assumptions required going-into a business modeling exercise

• Next session will cover:

— How to translate your business model into funding and capital requirements (inputs: traffic analytics, sales mix and cost structure forecasts)

— Valuation projections for your startup under most likely scenario

Thank-You!