When you start a company you naturally have two immediate and equally pressing priorities. Those priorities are to solve a problem for customers and to validate that you can make money solving that problem.
To validate that you can make money and to understand when you’ll make it, you need to build a pro forma income statement. A pro forma income statement shows how much revenue you expect to receive from the sale of your product and what expenses you expect to incur over your first few years of doing business.
Three basic approaches exist to predict startup revenues:
- You can just guess. But beware! Nobody will believe the numbers.
- You can estimate that you will achieve some percentage penetration of the total available market. Sadly, nobody will believe these numbers either.
- You can determine which processes you will use to achieve sales, estimate how efficient those processes will be, and then derive how much revenue you will achieve based on those assumptions.
This article explains how to do startup revenue estimation using the third approach. It involves the calibration of seven key variables. You’ll start with the initial estimation of the seven key variables and then refine them as you learn actual values.
The Seven Key Variables:
- Customer Acquisition Cost (CAC): For those new customers that you attract as the result of your marketing activities, how much does it cost you per customer? This is one of the most difficult to estimate. You will start with just a guesstimate based on the (very) few published data from other companies in industries similar to yours and using sales techniques similar to yours.
- Sales Cycle (SC): How many months transpire between your expenditure of marketing dollars and the acquisition of new customers? This will also be just a guesstimate based on your past experience.
- Average Order Size (AOS): How much revenue do you expect to generate each time a customer makes a purchase? You should have a pretty good idea of what you want to achieve here based on your product, pricing, and business model.
- Periodicity (P): How often will each customer make a purchase? You should have a pretty good idea of what you want to achieve here based on your product, pricing, and business model.
- Retention Rate (RR): What percent of existing customers will remain customers at the end of each year?
- Viral Coefficient (VC): How many people will each existing customer attract and successfully convert into new customers? This is a one-time conversion; once a customer refers this many new customers, we assume they no longer refer more new customers. Very few companies achieve a VC as high as 1.0.
- Viral Cycle Length (VCL): How many days will transpire between customers becoming new customers and their referrals becoming new customers?
Before you launch your company, verify that the estimates you’ve made for the 7 key growth drivers could result in a successful company. That is, there must be significant revenues and profit, and solid returns for all shareholders to be considered successful. If not, realistically adjust the values until the company shows returns. But don’t just change the values to make the company look like it will be successful; the new values must be achievable!
Refine the Seven Key Variables:
After launch, every month, compare your actuals to your planned values for the 7 key growth drivers. Enter actual values for CAC, SC, AOS, P, RR, VC, and VCL into your plan. It might be helpful to graph each one. You will likely find that
- CAC and SC will start off quite large and will only converge to stable (and lower) values after you learn how to find your target market and how to optimize your messaging.
- You will not be able to ascertain actual values for RR, VC or VCL until after a year or so.
Verify that the actual values for these 7 key growth drivers still result in a successful company – i.e., significant revenues and profits, and solid returns for all shareholders. If so, you are on track! If not, you need to pivot.
How to Change Actual Values for the Seven Key Variables:
- To decrease CAC and SC: Improve your understanding of the target market. Hone your advertisements to the specific pains of your target markets. Focus on benefits rather than features of your products. Offer better pricing or better promotions to increase close rates.
- To increase AOS: Offer quantity discounts. Improve your product.
- To increase P: Offer frequent buyer programs. Improve your product.
- To increase RR: Improve your product’s stickiness.
- To increase VC and decrease VCL: Offer referral programs, especially ones that incent both referrer and new customer. Make products so exciting that they create a buzz. Add features that increase your product’s value to customers.
As you can see, these seven key variables are fundamental to understanding your startup’s revenue. They are not easy to estimate, but you can at least determine during the planning stage what values you must achieve to be a viable company.
ABOUT THE AUTHOR:
Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.