Financial Model – What is it and Why do you need it

The financial model is the most often overlooked portion of a Business Model. When it exists it is usually a spreadsheet reassuming overall costs and overall revenues. It is prepared once with some assumptions thrown in and then forgotten. The financial model is one of the most important tools of a Business Plan. When done properly it will indicate how much money is really needed and if updated daily can let you know exactly where you are. Missing numbers is accepted on big companies because even when they miss rarely will their shortcomings determine a dire economic situation of the business.

With a start-up or small business this is not the case. With a good financial model, updated daily, and dynamic assumption fields the financial capabilities of the next six months will never be in question. Most people think of the financial model as a crystal ball. How can you know what will happen tomorrow? So they prepare numbers in a way that represents what they think someone else wants to see. This is a recipe for disaster and can mean not financing your company or receiving significantly fewer funds for a larger portion of the company. It is normal practice for a private equity firm to identify a problem in your model and give you what you ask for including some clause in the purchase contract that gives them first right of refusal or limits your ability to access alternative financing without their approval. You have, at this point, given away your time, and your company. You just are not aware of it yet.

A financial model will tell the story of your company in numbers. You could see it as a numeric version of your written Business Plan. Since writing a financial model is not intuitive for most entrepreneurs I strongly suggest you find a good modeler who is capable of understanding your business. It will cost you anywhere from $40-100 k but it is well worth the money. If you do not have that type of funds available, particularly in the start-up phase, look for a modeler who will take a piece of the company for the work he will do. It will take anywhere from 4-6 months to prepare an appropriate model but it should allow you to update data on a regular basis and return everything you need to run the business. Most importantly it will tell if you will really make money by implementing some procedure or by introducing a product.

Each business is different but each business is the same. This is no more evident in any tool than with the financial model. This does not mean that you can just buy some model off the web but it does show the relationship between the various resources of your company. The financial model also tells you a great deal about the entrepreneur, how accurate his data is and whether or not he understands the various aspects of his business.

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The Marketing Plan - Determining the Appropriate Price

The actual process will take several weeks and should not be rushed. The initial thought is that the product is priced to perfection. The competitive market analysis says the price is right, your sales team is excited, and you have a good gross margin on the product. Nothing can go wrong. It is important to realize that the best product or best price/quality relationship is rarely the best selling product. Remember a good deal is one that the client perceives as a good deal. Another important factor in pricing is that pricing will change the quantity sold. Will you sell too little product driving up the fixed cost or will you sell too much requiring that you increase your production facilities? Although it may seem that you need a crystal ball to make the appropriate choice, this simple process will allow you to price, verify your assumptions and make the appropriate adjustments to hit your objectives.

Marketing, sales and financial teams need to be involved. Set up a straw man model, inserting the cost structures and the revenue streams. The key is to understand how price and quantity affects margins, infrastructures and the bottom line. Graphs are great visual support but I prefer a spreadsheet. The initial product and pricing has already been set. The sales force must commit to the quantity the sales force will sell.

Once the Sales force has committed to a number, they should explain exactly how they intend to achieve that number. In other words how many packages each salesman will sell. How many will be sold every day? Is there lead-time necessary for the sale of the product? At this point the question is how many have you sold of a similar product? How much time was required for each sale? In other words the entire group must challenge the sales force’s capacity to make the numbers. At the end the number will change, higher or lower but it will change.

The Financial team should plug the pricing and sales numbers into the model both on a weekly and a monthly basis. The numbers should then be matched against productions capability to produce and should sales be back loaded a cost should be added for inventory and storage. It should also be assumed that 50% of the inventory will go unsold.

The financial team will indicate that the numbers work or they do not. If they work then marketing needs to adjust its advertising and support programs and indicate whether or not the addressable market can actually be acquired. Marketing numbers will most likely change and need to be inserted into the model by the financial team.

At this point the financial team will surely say that the numbers no longer allow sufficient gross margins. Everyone will be frustrated and throw their hands in the air and argue. Negativity will abound. Phrases like:

“Well then we just kill the product.”
“What do you mean we can’t do that?”
“Why are you against this launch?”

At this point, stop. Make sure everyone has a complete copy of the charts, the proposals and the numbers. Go home and come back after one week and start over. This will take several weeks. If it does not it is most likely you are not prepared to launch the product. In all of the product launches I have followed we have never seen the pricing be correct on the first try.

This process will help the entire executive team understand what it will take to be successful. It will also help understand the importance that the entire team meat their daily, weekly and monthly goals. Remember, you can always cut costs, but if you do not have sufficient revenues you will bankrupt.

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The Marketing Plan – Is your Product, at the Proposed Price, Profitable?

I know you could spit on yourself repeating the title of this article but the topic is important, extremely important, so we must proceed at the risk of spewing ourselves with saliva. The product characteristics have been determined. The product positions somewhere between to price points. The natural tendency is to price the product in the lower price range, but this may be a grave error. Even without a financial model profit margins can be determined. This is not a job for the technicians. They are excluded from the next step. The financial team is important and they must be added.

The first step is to determine the most obvious product costs. These are Cost of Goods Sold and generally include raw materials and labor. Sales or client acquisition costs must also be determined. If you have a production facility it is also important to understand how much a given product can be produced in a time period with stepping to the next level. This is because most production costs are like stairs. There is a basic cost to produce 1 piece of a product and the incremental cost is relatively small, then at some point of production the company needs additional employees, machinery, support staff causing a step like jump in cost structures and producing just one more piece will cause the cost structure to increase disproportionately. These steps will help determine the price point.

Here is the first objection, “Price and cost have nothing to do with each other!” Yes, this is true. Price is determined by demand while costs are, well, many other things. However, the demand is also determined by price, which is, at least theoretically, “if you increase price you reduce demand”, you can apply the price/demand model to your production cost structure and capabilities to find the optimum price point. Ah the counterintuitive dilemma, “selling more is not always better.”

So, the question arises, “Why should you care about this, all you want is for me to say the company is a good investment, the product has an addressable market?” The answer is simple, investments based on market share, number of clients, page views, are smoke and mirrors business models. They are kept primarily for publicly traded companies not for private equity. Private equity wants to know that you can get a certain return on the capital invested and that you can make money. Once I start looking at your product mix I will ask, “Why did you price your product where you did?” Your answer, and the way you arrived at that determination, will be an important part of my due diligence.

There are many good sites with a great deal of information about profitability and accounting. One I found by accident can help in determining if your product is profitable, the Bean Counters Site.

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The Marketing Plan – Package and Price your product

Pricing your product is one of the most important parts of a successful plan. Remember it is not the best price quality relationship that wins but the best price quality relationship perceived by the client that counts. To know what is important and what is not you must know what characteristics of your product appeal to your clients and what things they would like to have. I have often found that it is possible to put two products together with a significantly higher price than the two pieces separately and the bundled product sells more than the individual products. Perception is reality and you must use this to your advantage.

While the steps are simple, time and attention to detail are extremely important. Several groups will be involved. Your sales manager, your marketing manager, a successful salesman, a customer service manager or representative, one of the technical team, the product manager and two other individuals who have little or no knowledge of the product.

The next step is to identify what the technical, marketing and sales teams feel are the strong and weak points of the product. It should be noted that price is not a factor at this point and should not be part of the equation. They should them describe the competitor’s projects in the same way. Close these reports away in a secure area.

Bring the entire working group together. Give them the product, have them take it home, install it, prepare it for use and then use it. Write down every perception about how this process goes, no matter how stupid it may seem. When I wrote software and thought I had a viable product ready for release I would give the finished product, in the box, to my eight year old daughter and she would then install, configure and start using the product on the home computer.

I followed what she did without ever intervening, simply noting how and what she did. If she ran into a problem I would not help and encourage her to read the manual. I would then continue to document her progress. This saved numerous horrific product launches.

The next step is to do the same thing with competitive products, both above and below the intended price point. It is imperative that the documentation be realistic. It does no good to say the product worked in a way described different from how it actually worked. Ask the group to spend extra time identifying the positive points of the competitive products.

Now comes the fun part. Bring the entire group together. Product by product, go over the things you thought were important and the things that using the products showed were important. Weight each of the identifying features of each product from 1 to 10.

Now separate the characteristics by the price of the product. At this point you may find that the most important features are not necessarily in the most expensive products. It will also allow you to see at what price point the competitor satisfies most of the client’s requirements. You are now ready to make the first attempt at determining your price. Do not be tied down by the current development or packaging of your product. If your initial studies were correct there will be very little to change at this point. It is better to rework the product and sell at an appropriate price than put out a product that cannot be sold without significant discounting.

There are numerous other steps necessary before arriving at the final price, including financial modeling to determine if you can sell the product at a profit, but this is a good first step.

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The Marketing Plan – Price Your Services – What not to do

You have done your competitive market research and have identified the strengths and weaknesses of your competition. You have a good handle on their price points. You know your product is better. You can price your product just under the competition and you will take your market share. There are even studies and mathematical equations that indicate that pricing your product 20-30 % under the latest competitor will give you a 10-15% market penetration. You do the numbers and price your product. You are set to be a successful entrepreneur. All you need to do is get the word out and you are set.

Unfortunately, it does not work that way. This is a Marketing Plan of Failure. One of the immediate red flags I identify is when the use of funds indicates an amount for advertising. It means that the company has used this type of methodology in determining pricing, which will most likely be too low to cover production and sales costs, and revenues, which will be too high because it just does not work that way.

To help understand why this common thought process is completely off base we need to look at a couple of factors. First the price/quality ratio is perception. Very rarely is the best product at the cheapest price a market leader. The market leader is the product that the client quickly identifies as the best product. Second a plan based on the lowest cost provider model always fails because there is someone out there who can do it better, cheaper, faster or who does not care about making money and will sell the product at a loss just to keep others out of the market. Finally, while it is the entrepreneur’s nature to be optimistic about future sales, he often overlooks many of the costs of doing business or producing a product.

Let’s take a bank’s checking account as an example. Most banks have come out with a plan where you pay $10-12 a month and on every movement you acquire points that can be redeemed for awards or sometimes, even money. You think this is great, I can earn points toward vacations, hotel upgrades, a big screen TV, and or even get part of my money back. Sounds great, but it is not. A closer look at the product shows that while you will pay $144 annually you can only earn about $100 in benefits. If you close the account early you are responsible for fees to close the rewards program and if you do not have enough points they are just lost. So in the worst case the bank makes $44 for doing nothing and in the best case makes $144 and keeps its client tied into the account for other services. The best deal on the account is the free checking with direct deposit. No frills, no interest, no nothing but it is the least expensive way to use the bank’s services. So why do people choose the rewards accounts, because they perceive they are getting something for nothing.

The most well known example of the imminent failure of the lowest price business model is the recent bust in the Telecommunications industry. Every new player that entered the market dropped prices by 30%. They did not anticipate that there would be other market competitors and as they took market share from those already in the market these competitors would also lower prices. In the end the corporate earnings across the board were severely damaged. All of the new players went bankrupt and the only ones left standing are the ones who were already in the market and had significant cash reserves and existing networks. Today the companies created from the deregulation are now coming back together. In thirty years the cycle has come full circle.

Finally, I know you think you know what it costs to build your product. You may even have signed a contract with a foreign company to build it cheaper and better but every business decision has consequences and is sooner or later reflected in the costs of doing business. Let’s say you decide to build your product in China, what happens if the product quality drops just a bit and the number of returns increases as a percentage. A good friend of mine who brought the first cell phone to production for Motorola told me horror stories of ramping up production. Fortunately Motorola had deep pockets and was able to source materials and people to make things work but they did it at 500% of the original budget. I have seen this across many sectors in both products and services.

I know this all sounds negative instead it is reality. Your plan needs to take these thoughts into account and your judgment must be cautious both on the cost and on the revenue side. A wrong step and you will most likely lose your company and all the work you have put into it. Some venture firms will identify cost or revenue variations and not say anything. The deal will be structured in a way that gives them control should the financial parameters vary more than a predefined percentage. When it happens, because it will, they walk away with the company, replace you with someone else, pump in some new money and sell the company for 4 times what they invested. Be careful and be cautious, it is your money and your life’s work we are talking about here.

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The Marketing Plan – Define your Competitive Environment

You may think you know, intuitively, your competitive market but take the time to do some research. There are many important things that once written down and placed into a window give insight that will allow you to better structure your marketing plan. There are numerous ways to get this information. I usually start from publicly traded companies, get a list of the major competitors from Yahoo Finance and then check the press releases. Google also does a very good job getting the information about market sectors. Some things often overlooked are local, state and federal governmental regulations, anti-competitive hooks in major competitor contracts, and available of financing for the proposed business environment.

Let’s say your company provides Hospice services to rural communities. The addressable market is easily identifiable, it is a tremendous growth area and the competition is rather limited. A search on Yahoo identifies numerous Health Care Management companies working in the space. A closer look shows that these companies are dedicating their resources to larger population centers. Reading their press releases it becomes evident that they are doing this because there are limited number of healthcare professionals, thus the professionals are requiring fair wages. Most importantly, since much of the Hospice work is done in the patient’s home, the healthcare professionals are asking to be paid for traveling to and from the patient’s residence.

The price paid for the services would easily cover this additional cost of travel however given the corporate structure, these are publicly traded companies who must return 18% to shareholders and cover general and administrative costs, the company locates its facilities in large population areas where they can benefit from economies of scale allowing the company to save on travel expenses. It is also possible for these companies to leverage more qualified personnel with less skilled labor in the large population areas. This would not be possible where the patients are not concentrated in a small geographical area.

Governmental regulations also play heavily into the administrative costs of this business since, more often than not, these patients are covered by Federal Health Insurance Programs. These programs are costly to administer and often require specialized employees in order to receive fair and timely compensation for the services provided.

Knowing these basic characteristics tells us numerous things. Most likely large corporate entities will not attempt to compete in our addressable market. It also says that we do not want to count on significant revenues from larger population centers, and finally we need to structure our company to have qualified personnel involved in both the care giving and administrative services. Finally it also tells us that we do not want to attempt to source aggressive money. Aggressive money will, over time, force the company to make bad business decisions and eventually fail.

Know your competitive market before you define your plan. Buy their products and try their services. Understand why they have structured the way they have and you are one step closer to success.

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The Marketing Plan – Define your general market

The Marketing Plan is probably one of the most important parts of any business plan. There is a very good and simple reason for this. While a company can look at procedures and find ways to increase productivity one of the things it cannot do internally is increase sales. The most efficient business will fail if it is unable to sell its products. For some reason it is rare, even in publicly traded companies to find a good sales and marketing plan. Usually it says something like, “there are 10 million users and we will take 10% in the first year,” or “The average return per advertising dollar is 12 x 1000, we intend to spend 1 million $ in advertising.”

These are not marketing plans. The mean absolutely nothing and will result in a negative opinion from most due diligence teams. Investors do not want to throw their money at advertising. They do want to see sequential growth, usually based on some historic data tied to different, well documented, plans. They want to know the business environment. Yes it is important to know how big the addressable market is but it is more important to understand how your company has acquired clients in the past, how much it cost to acquire each client and how your company intends to ramp up future acquisitions.

It is also important that your information be very product oriented. If you are selling in Atlanta, it is not important to say that the worldwide market is 100 times larger. It is important that you give a clear vision of how your company will dominate the market it is currently working in. It is also important to explain why your company has been successful in getting clients to move away from the competition and why some clients have left you. Finally it is important to understand the churn, that is the number of clients you lose in normal business and whether or not you can continue to acquire more clients than you lose.

The overview must explain who your client is, what are his revenues or disposable income, what is the current environment, if the current economic environment in your market changes how will that influence your client’s spending and decision making processes. It should also take into account how your differentiating factor will be influenced if general economic conditions change. It is not sufficient just to state these facts, you must research them and support them with credible, outside sources.

Sounds simple, I know, but this is one of the basic building blocks of any company.

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Business Plan – The Vision Statement

“I have a dream!” This famous phrase by Martin Luther King motivated millions and unified the most different thoughts into a force working toward a unified goal. Your Vision is none less powerful or important. The Vision Statement is how you see the future business environment and how your company fits into that environment. As a dream, it is not specific, nor does it need to be crystal clear but it should allow others to understand, in general concepts, how you think the future will look.

Your dream does not have to be widely accepted by others, if it were then you would not have a differentiating factor, you would not be visionary, you would not be a leader, you would be the masses. It does need to coherent with the business you are creating or the way you are restructuring. Several years ago I restructured a steel manufacturing company.

The company had seen falling sales and the 80 year old owner wanted me to help him restructure before handing the company to his children. He thought about investing in newer more efficient ovens and automating various parts of the process. While at dinner one evening I asked him about his vision of the future. Shortly, I understood that his vision did not have the wide scale production of Italian steel. His thinking was that it would be too expensive, given energy costs, to compete with less developed markets.

Over the next several weeks I worked a plan based on his thoughts. It included shutting down the ovens and developing a niche division of the company as the primary business. It was not an easy sell. The business he had created had provided for numerous jobs in the community would be cut by 70% over the next two years and their were no guarantees that the niche business could actually bring the company to the current status.

He finally embraced the plan. Today the company still has not returned to its previous number of employees but is significantly more profitable and boasts worldwide dominance in what was once an afterthought of a business. The old gentleman has passed away but his children still operate successfully the company.

You must have a Vision, and everything you do must be compatible with that Vision.

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Business Plan – The Credo

The Credo is not found in all Business Plans. I feel it is extremely important. It ties the company’s Vision to the company’s Mission and Values Statements. The Vision could be seen as the way the entrepreneur sees his company in the future general business environment. The Mission is what he intends to create to secure his place in the Vision. The Values statement indicates what the parameters of operation look like while attempting to achieve these goals. The Credo tells the reader how the company intends to execute these goals. It could be seen as the way the objectives can be reached to realize the Mission inside of the Vision while adhering to certain Values.

A coherent Credo will allow the investor to understand a plan that he thinks has value but is not quite sure how to verify it. A Credo will also help your employees understand, with practical examples, how to think about everyday business development. Here is an example of a successful Credo:

We are dedicated to those who use our products and services. In meeting their needs, we must produce quality services. Our objective is to serve our customers as they want to be served, providing quality services at reasonable prices. We must anticipate the technological advances in the market, continuously improving and developing our product and service line. Quality control must be an integral part of our process creating long-term relationships with our client base.

Our employees are respected as individuals and are compensated in a fair and adequate manner. We recognize their merit and respect their dignity. Development and advancement for those qualified will create an atmosphere where suggestions and complaints are possibilities for growth and unity. We must provide competent management, and their actions must be just and ethical.

Our final responsibility is to our shareholders. Business must make a sound profit. Research and Development is our future. We must purchase new equipment, new facilities and launch new products guaranteeing the investment of those who believe in our company. Reserves must be created to provide for adverse times. Our shareholders should realize a reasonable return when we operate according to these principles.

When a company does not stay in line it will most likely fail and in the best of cases have problems with the investors. Recently I looked at a company for a rather small investment. The teaser indicated that this company intended to recreate the Italian dining experience in a limited number of restaurants in the US. Their documentation indicated that they had several restaurants in Italy and had successfully developed a look, feel and service structure of a family owned Italian restaurant.

They listed the following reasons to support their plan:

Experience
More than fifty years combined experience in restaurants and Food & Beverage and have opened more than fifty restaurants world-wide.

Knowledge of Italian culture & cuisine
Knowledge of Italian culture & cuisine. Instrumental in the original Sfuzzi Concept and have lived and worked in Italy creating Hotels, Resorts and Restaurants.

Service level
We have developed a service training program “The Fine Art of Hospitality” to deliver impeccable customer service.

Product quality
We will utilize the efforts of accomplished Italian Chefs as we continue our involvement in Italy today.

However, they do not adhere to these concepts in everyday business decisions. I received a copy of a letter sent by a 30 year veteran of the wine business following an encounter with management evidencing numerous variations from the described plan. Some points that immediately caught my attention were:

Who is the audience you are seeking with your list in this resent incarnation? In other words, in the words of what we all do everyday, who is your target?

From our earlier conversation I thought you folks were looking to be an Italian experience that one would find in Italy.

Italian places don't usually serve Spanish or French wine. I can understand Texas wines because that is the region we are in and it is showing a connection to the region and her produce.

I don't understand having Pinot Noir on the list except to cash in on a trend that really has nothing to do with Italy (and which will pass). Ditto with Merlot. And Cabernet. Unless they are sourced from Italy, of which there are a lot of excellent choices.

From the expert’s comments I was able to identify what I felt was a primary flaw in the business model. The company was making the same mistake as most Italian restaurants in the US. It was attempting to use the idea of Italy as a marketing tool while providing an American experience. This model usually works well for low end places like Olive Garden, Campisi, and Macaroni Grill but fails for just about any other type of model that is not mass market.

In this particular example the company ignored the fact that Italian dining is not a flavor of food instead it is an experience and a way to see the world. While the mass market Italian places will cover everything with garlic, oregano, garlic, rosemary and more garlic and this works fine, a qualified Italian restaurant must use fresh ingredients, have knowledgeable staff, not turn tables, pair wines and generally recreate the concept of balance in life. This company was thinking about serving the mass market while telling his investors that he was trying to work in the quality niche segment.

His positioning in the mass market is fine, no problems, but the investors should be aware that this is his target so they can effectively evaluate his capability to compete with Brinker, YUM Brands, et al. It may be simply that the wine director of the restaurant was not completely aware of the company’s goals and objectives. Either way it does not matter, the end result is a company that says one thing and does another.

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Business Plan – The Mission Statement

The Mission Statement seems to be another one of those declarations that everyone has in their business plan and no one knows what is in it and no one really cares. Often it contains statements such as, “We will be point of reference for the market.” Others play to the opinion that an aggressive statement such as, “We will dominate the internet space,” shows desire and high self-esteem. If you have statements like this, eliminate them. They do nothing toward helping the people around you understand what you want to do and make you lose credibility with those who might invest in your company.

The Mission Statement is an outline. Think of it as a general description of your plan of attack. It should help your employees understand what type of operations are in line with the overall objectives of the company and allow investors determine if your current strategy is in line with where you want to be.

The Mission Statement should also be synchronized with your Statement of Values and your Vision of the business environment. In other words if your differentiating factor is customer service and your Values Statement indicates that return on investment is the most important thing to the company you have a problem. It is important to think about the relationship among the various factors influencing your company. Is it possible to accomplish your mission considering your Vision of the market and the way you intend to interact with employees?

The following is an actual Mission Statement from a plan that was financed for $46 million US:

Our mission is to develop national networks for voice telephony and data transmission in European countries experiencing de-regulation and in the emerging Eastern European and Latin American markets. The company’s infrastructure exploits the technological advances in voice telephony and data transmission to offer quality services at a reasonable cost allowing our customers to become leaders in their own fields.

Think about these statements. They can help you stay on track and communicate your message to those around you.

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