Tse financial viability of a business model 2014

Financial viability of a business model

The Smart Entrepreneur

Assessing financial viability early – What’s this?

• Early assessment tool /process to test the financial viability of a business model

• Key outputs include pricing and volume: what do I have to do to cover costs and achieve breakeven (profitability)?

• The introduction of “risk” as a financial concept: Do the returns compensate for the risks I am taking as an entrepreneur?

• Provides early indication whether outside investment might be needed to get to breakeven

‘Sometimes there is a gap in the

market because there’s no market

in the gap’—Irene Bejenke-Walsh

MessageLab

Copyright of Bart Clarysse and Sabrina KieferThe Smart Entrepreneur

http://www.messagelab.co.uk/

Why?

To really be feasible, a business model must make sense

• not just strategically (where you have a compelling and competitive product offering and route to market),

• but also financially (so that you will earn more than you invest!)

• This also makes sense for a social/non-profit enterprise – you still need to break even!


Why now ?

• Comes before and informs both the full market testing and the full financial projections

• Prompt for entrepreneur to adopt an investor mindset

• Qualify & quantify financial objectives and priorities early in the process

• Assess early whether changes to the business model will be needed.


Two paths...

Financial viability has different parameters depending on whether you intend to enter:

1. A market for products

• making/selling products to customers

1. A market for technology

• Licensing

• Building then selling a tech company before reaching revenue

Your choice of market might even depend on the respective financial viability of each option.


1. Market for Products

Is there a ‘market in the gap’?

This section was co-authored by Irene Bejenke Walsh, MessageLab


http://www.messagelab.co.uk/

1. Product Market

If you aim to pursue a route to the Market for Products (See ‘Clarysse model’ in Teece analysis slides in Business Model tool)

1. Value Proposition based on Product Offer (or standardised service)•Specific product / market niche•Control over the value chain •Diverse founding team with experience in industry•Funding from founders’ own capital, debt or possibly an Angel, followed by early revenues

-> Revenue Growth by selling standardised products to customer segments


Key questions to address

• Do the returns on investment compensate for the financial risks

involved?

• Can I make a product/ deliver a service which is competitive on a breakeven basis ?

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• Is the addressable market big enough to make commercial sense? (See Entrepreneurial Market Research in IE&D Toolbox)

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• How long before the business is self-financing and hence…..

• …will I need outside finance ?

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The 3 Components of a “Market in the Gap” Analysis

• Addressable market: this needs to be big enough, offer enough potential customers/revenues to make the company scalable (See also “Entrepreneurial Market Research” in IE&D Toolbox)

• A viable business model would satisfy all 3 components opposite

• “Return on investment” is used here as a conceptual term for a number of key financial issues entrepreneurs have to consider in the start-up phase, e.g. cash and time they are investing themselves, and how they want to be compensated for their investment.


Breakeven Analysis

This is a rough test to work out how much we need to charge for our product or service (i.e. the lowest price) in order to at least cover our costs, i.e. get to breakeven.

•Once we have determined a breakeven price for our product or service, making a few basic volume and cost assumptions, we can answer the question: is our ‘breakeven price’ competitive in the market?

•If my breakeven price is already higher than that of the nearest existing competitor(s), we are facing a competitive and financial challenge with different potential outcomes (or a negative business case). The idea is that the business model has to stand up at a minimum to this simplified P&L model to assess financial viability.

•This is an interactive process, e.g. a negative business case result may cause us to review our assumptions and thus produce a new/ lower breakeven price.

•Depending on our funding, we may be able to tolerate a negative business case in Year 1 provided we are confident that the cost base will improve in the near term (also known as ‘cost leverage’) – this is then an issue for a more detailed financial modelling exercise to determine when breakeven occurs and how viable this is for us.


Cost analysis

Fixed Variable

Explanation Costs that are the same regardless of how many items/ services you sell – sometimes described as the costs you need to incur before you are able to sell

Recurring costs that you need to pay with each unit you sell – naturally for some cost items (eg raw materials), the per unit cost will depend on volume

Example Development costs, property costs, marketing, IT costs, finance costs (though this depends on how the business is financed - debt or founders’ equity)

Cost of raw materials, distribution costs, product-based labour/ staff costs, royalties


Breakeven Analysis - Example

• Our business idea is to make a new digital eco mousetrap, the E-trap. Its USP is that it humanely contains rather than kills the mouse, sending out a digital signal upon capture.

• Competitive products, none of which have our USP, are priced between £2 and £5.

• We have decided we need to pay salaries, including our own, of between £100k and £120k per annum (note we may choose not to pay ourselves and effectively contribute our time at this stage).

• What is our breakeven price under various volume assumptions and is it competitive ?


Breakeven Analysis – Rough P/L

‘E-trap’ Cost Item Year 1100 vol case GBP’ 000s

Year 11000 vol case

GBP’ 000s

Fixed costs Founder salaries

100 120

Marketing 50 50

Variable costs

Raw material costs

300 600

Product-based labour costs

50 80

Distribution costs

100 150

Total Costs 600 1000

Breakeven Revenues 600 1000

Breakeven Pricing 6 1

• We have produced a rough profit and loss for the first year (opposite) comparing two annual volume assumptions (100 and 1000 units).

• Variable costs - We have sourced component suppliers and distributors and costed these on various volume assumptions – e.g. £450,000 on assumption of 100 units sold.

• Fixed costs - We have made some assumptions as to our ‘required’ salaries and marketing costs – e.g. £830,000 on assumption of 1000 units sold.

• In our example, our breakeven price per E-Trap is thus between £1-6 based on volume assumptions between 100 and 1000 units sold.

Breakeven Analysis – Breakeven prices and market

• In our example, our derived breakeven prices of between £1 - £6 compares with a range of £2 – £5 in the market for existing mousetraps.

• We now repeat this exercise for various volume assumptions.

• The chart opposite shows a plot of breakeven prices at various eco mousetrap volumes in year 1 (includes points A and B giving breakeven at prices of £1 and £6 as set out above) with an overlay showing competitive pricing.

• Conclusion (1): Our product is competitive on a pure pricing basis if we can sell more than 500 E-traps (in Year 1).

• Conclusion (2): We may decide that our product will justify a pricing premium given its USP. This would cause us to re-calculate and result in a lower breakeven volume.

Breakeven prices

Product

volu

me

Competitionprice points £2 - £5

100

1000

1 6

500

2 5

A

B


Can we achieve those criteria?

Later, when you go into more extensive Financial Planning, you will look more carefully at whether you can achieve the criteria for breakeven by considering the sales cycle and likely time needed to get a first customer and to sell each unit of product

• Assess these assumptions in your Market Testing (IE&D Toolbox)

• for B2B, see Sales Plan tool in Roadmap slides in the IE&D Toolbox

For now, it is useful to have an idea at the start of what the tolerable parameters are.


Quantifying your risk & investment• Calculating risk and investment as an

entrepreneur are essentially subjective exercises.

• Two parameters to consider at this early stage are money and time invested and how you want to be compensated for these.

• Money: how much cash have I invested in the business, when do I want/need the money back and at what return? If I have re-mortgaged my house and invested £50K, personal finances might be tight and I will need a certain level of return to pay for the cost of finance.

• Time: How long will it take to get to breakeven point? How long can I go without a salary? If I have invested in “sweat equity”, i.e. unpaid time, how much is it worth and how much do I need/want to earn?

Note: typically, third-party investors require at least a 25% rate of return to invest in a start up business, this means that a business has to return 3x the original investment over 5 years.


The concept of return on investment

• All businesses involve risk and some businesses are riskier than others.

• Higher risks are acceptable provided they bring the prospect of higher financial returns.

• At one level, a founder is an investor: someone who invests his or her own time and/or money in a new business idea or venture.

• A venture is only viable , if it compensates the founder for the risks incurred, i.e…

• …if the founder’s return on investment exceeds the risks involved.

• For these purposes, the return in a venture and payback over time could be expressed as the equivalent annual interest rate you would receive on the same amount of money invested over the life of the venture

Question: would you expect to get back more money from a £100 investment in a business start-up or a £100 deposit in a domestic bank account? Now ask yourself why ?


Risk & return - market rates

Expected Return level %

Risk level/Company stage

0 – 5% No/ low risk, e.g. bank accounts

5 – 15% Mature businesses/ quoted companies

15% - 25% Early stage businesses/ unquoted companies/

higher risk quoted companies/

25% plus Unquoted start up businesses

• Risks can be characterised as the extent to which you are willing to forego more certain returns?/ ie how much money are you prepared to risk or lose?

• Measuring risk is subjective, but market comparisons and benchmark returns exist

• New business ventures will tend to fall in the final category


Risk & return - summary

•Even if we have a competitive product from a breakeven analysis perspective, do the returns compensate us for the risks we’ve taken as founder/ investor ?

•What constitutes an ‘acceptable’ return is influenced by: • the financing structure of the business (capital investment,

cost of finance) • the nature of the business model (how much could you lose?) • and the entrepreneur’s own circumstances (how long can I

wait for a payback?)


Possible outcomes

Market scale

Breakeven analysis

Return on investment

Comment

No Addressable market too small

Yes No No Big enough market, but chosen product not cost effective and hence poor return on investment

Yes Yes No Big enough market, competitive product, but limited expansion (or premium product) opportunities limit financial returns

Yes No Yes Big enough market, but product not competitive in early years

Yes Yes Yes Big enough market, competitive product and appropriate financial returns : ‘market in the gap’


Improving the gap – possible changes

Failed on Operational change Financing change

Market scale Consider other complementary niche markets

n/a

Breakeven analysis Change the cost structure (new route to market, leasing key assets, cut salaries, staged launch). Consider adding complementary product line

Change financing structure (financial investor/ strategic investor) so you can tolerate early stage losses for longer

Return on investment As above and consider a faster roll out

Introduce more debt and/or equity investor


2. Market for Technology


2. Technology market – IP licensing

If you assess an IP licensing business model, financial viability analysis is similar to that for products

In other words, assess

1. your addressable market size:

• For what applications could you license? Which industries would be most interested? (T/A Matrix in IE&D Toolbox)

• How big is the addressable market? (Entrepreneurial Market Research)

(e.g. ask ‘preferred witnesses‘)


IP Licensing business, continued...

2. Your breakeven prospects• What are licensing fees for comparable

technologies (pricing)?

• What are the legal/IP protection costs? (could be high) (again, ask ‘preferred witnesses’)

• Licensing is not a labour intensive activity;» How can you keep overheads low to

maximise profit?

• But licensing fees are usually not huge;» What volume of business is needed to reach

breakeven/profit?


IP licensing, cont...

3. and your risk/return profile.• How much time/money needed to

reach that volume (acquire licensing customers)?

» And how much are you willing to invest yourself and wait before payback?

» Would you likely need to raise external capital?


2. Technology market – building toward a trade sale

If you are considering the route to the market for Technology via a trade sale rather than revenue (See ‘Clarysse model’ in Teece analysis slides in Business Model tool)

2. Value Proposition based on Technology Offer•Focus on developing one application•Build a technology team•Establish technology partnerships•Source specialized VC for start-up and development capital

-> Employment Growth to build up intellectual capital, with view to a trade sale


Technology business model – financial viability

1. Look at acquisition prices of comparable companies

2. Assess the stage of development those companies had reached when they were acquired

3. Assess what market conditions were like at the time

4. Estimate the potential value of your business at similar stages and market conditions

5. Evaluate the return on the effort and investment needed


Look at comparables – Steps 1 and 2

1. Look at comparable companies (similar industry/market) where early investors exited via a trade sale pre-revenue• What was the acquisition price?

2. At what stage of development was the comparable company when it achieved that price? e.g.: • Med/biotech: It had passed a stage 2 trial, or it had undergone full clinical trials• Engineering: It had achieved a certain stage of advanced prototype or pilot tests; it

had built a certain amount of infrastructure• Digital: it had a certain size of user base, a proven user growth trend, etc.• And generally: employee headcount, size of technical team, size of general

operations, number of years the company has existed, etc.

Typically, at a more advanced stage of development >> greater acquisition price


2. Stage of development - value

You might try to extrapolate a value per asset ‘unit’ at those comparable companies, based on acquisition value E.g.

• Value per registered free user/paying customer (website)• Value per unit of infrastructure built (engineering)• Value of successful trial (medical), etc.

In other words, find a basis for comparison with your business


Look at Comparables - 3. Market conditions

3. What were financial market conditions like (esp. for private equity deals) at the time the comparable companies were acquired?

• Greater risk appetite among investors >> greater price

• Depressed financial market >> lower price

• How much competition was there on the market?• Was it a trendy sector? Investors trying to play catch-up to get into

the market >> price rises• Were there a lot of competing companies seeking acquisition?

>>price may fall

In short, what factors (stage of development and market) drove exit valuation at comparable companies?


Comparables and you – step 4

4. Estimate the potential value of your business at similar stages and market conditions• How long might it take you to achieve a comparable stage of

development to previously acquired companies, or comparable milestones?

• What could your ‘value per unit’ be at that stage?

• Consider possible business value in a buoyant or depressed market .

The above will be speculative, but can offer a starting point for considering a future value range (depending on conditions).


5. Is the business model worth the investment?

What kind of investment (£) would be needed for the co. to reach a ‘sellable’ stage? How much work?• Develop Management team, Tech team, general staff• Infrastructure• Achieving regulatory compliance• etc.

Given the cost, time and risk, would the final payoff (sale) reward you sufficiently?• For the entrepreneur this may be subjective• For a financial investor less so – typically seek a 50-60% annual return

or 10 times initial investment• e.g. Imperial Innovations aims for exit sales of at least £100 million,

besides a high return on initial investment


Conclusion

• An idea for a business model may be compelling from a strategic point of view

• ...but it also has to pass financial muster

• This is true whether you are aiming to start a profitable business or a social/non-profit activity, which must still break-even

• A financial viability exercise may also be a deciding factor in your choice between the market for products or the market for technology


Further Reading

Clarysse, B. and Kiefer, S., 2011. The Smart Entrepreneur. London: Elliot & Thompson, Ch. 7, 9 & 12.


Tse financial viability of a business model 2014

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