Gardner wrote The Startup Hats over Christmas 2013 and expects to publish it. In the meantime, he shares excerpts of each chapter with ExitEvent readers in 13 installments. Here's part three.
Wouldn't it be great if entrepreneurs could see into the future? We'd know which ventures to avoid and which ones will really pay off. We'd know how much money we were going to need and when. We'd be prepared for whatever was waiting for us around the next bend.
Starting a new venture is a lot like being Magellan or one of those early explorers sailing out into the unknown. It's the unknown part of the equation that creates the adventure's excitement and risk. Several of those early explorers didn't make it back. I don't remember their names because history kind of forgot about them. The successful ones that we do remember didn't just jump into a boat and hope for the best. Those explorers spent months, sometime years, planning and preparing for their journey. How big of a ship will I need? How much food? How will I deal with storms? What will the winds and current be like? And most important, what course is best?
The great explorers were good sailors, but so were the guys who drowned and starved. What made explorers successful was their ability to plan and navigate. Hope is never a strategy. Long before they stood majestically posed on the bow of their ship, they spent countless hours hunched over candles, thinking through every possible scenario they might encounter. These early navigators made best-guess assumptions about riggings, food consumption, wind and current patterns and modified those assumptions each day as new data was collected. They were great explorers first and foremost because they were great planners.
Successful entrepreneurs don't just jump in the water and start swimming. Like the Boy Scout mantra says, they were always prepared. The navigator's hat is one of the very first hats you have to put on as an entrepreneur. If your plan is not sound, then you really won't have a business at all. Planning or modeling a new venture as accurately as possible provides the insights needed to successfully surf the edge between growing your venture as fast as possible and not running out of money. It is the tool that will help you understand your costs and what resources you will need. More than any other document, it is also what is going to give potential investors insights into how their money will be used to generate a return and the confidence they need to put up the seed capital you need.
An assumption is anything that you might be wrong about or that might change as you try to forecast the most likely future of your business. Assumptions are things like the price you think your customer will pay, deal size, how much you will need to pay your staff, how many marketing dollars will you have to spend to acquire a new customer, and/or how many sales can your average sales person make in a month. Some models have a few dozen assumptions while others can have hundreds. Don't get one of those elaborate spreadsheet templates with dozens of tabs that will take you months to understand. Build your own. Start simple, modeling only the most salient features and variable that will most dramatically affect your venture.
First of all, you need to acknowledge what you don't know. What are the variables that will affect your business? There are many great discussions that this exercise generates around costs, sales cycle, customer churn, receivables/collection time, when to hire, etc. For all practical purposes, this spreadsheet forecast is your business. It is the steering wheel on your ship, without which, you are just waiting for monthly financials and guessing. All of the numbers in a given month's column are added or subtracted as necessary to produce the cash-on-hand number at the bottom of that column. This number is like the EKG bleep on a heart monitor. If it goes negative then your venture will most likely die on that date.
A big part of building a good starting model for your business is to acknowledge what you need to know and to hunt down reasonable starting assumption variables. This can be difficult, but you have to start with at least reasonable assumptions based on what you can know now.
I was recently working with a startup that wanted to sell HVAC air filters online via a consumer subscription model. A little research into shipping rates was all it took to come up with a reasonable assumption as to what their typical box shipping costs might be, but they also needed to know less obvious things, such as how often will consumers feel it is necessary to change their home air filters. They also needed to know things like what percentage of their customers would purchase the really cheap filters versus the more expensive and higher margin hypo-allergenic filters. Both of these numbers would dramatically affect their forecasted revenue, profit and the amount of money they needed to raise.
Sometimes, you can get reasonable starting assumptions from a proxy. A proxy is a mature company or proven model that is similar in some way to parts of your new venture. One the companies I am advising offers a tablet-based customer comment card for services-based businesses like restaurants to obtain customer satisfaction survey data. When trying to forecast what a restaurant owner might be willing to pay for such a tool, they were able to find similar offerings such as web-based surveys offered to customers via web addresses printed on their cash register receipt. Although not a one-to-one comparison, it did give them a reasonable data point as to how valuable restaurateurs considered this type of tool and in effect, what they might be willing to pay for something similar.
Sometimes you just have to be clever and diligent to get the data points you need. The subscription service filter guys needed to model a number for what their warehouse shipping clerks were going to cost each month. We were able to research help wanted ads to find out the typical salary range for shipping clerks. To find out how often consumers change their filters, they could have just hung out at Lowes or Home Depot in the air filter aisle and asked the people picking up filters how long it has been since their last filter change.
In "The Art of War", Sun Tzu said that no battle plan survives the first arrow. I'm not a big fan of a detailed written business plan, which always seems obsolete a month after it is written, but I'm a huge fan of a detailed spreadsheet model; a living document where the logic behind every number can be explained in detail and updated as needed. You can do a polished written plan if you choose, but those with the scars from many hands-on startup battles will tell you that in the early days, it is best to save your precious time for the spreadsheet model.
By "living document", I mean that the model is always being updated. I encourage entrepreneurs to establish the discipline each month of overwriting the forecasted cell equations for that month with the real actual data. Once you have the real number of sales for the month of March, you should overwrite the forecasting equations in these cells with that real sales number. Then look to see if your assumption to the left should be updated in light of the new actual data point. For example, you may have assumed that an inside sales person would close four sales per week, but for the last two months you notice that they have on average only closed 2.3 sales. Modifying the variable "average sales closed per month per sales person" from 4.0 to 2.3 will recalculate your model for all future months. Now, how does your model look? What changes might you need to implement based on your new forecasted future?
Over time, your spreadsheet model can become amazingly accurate at predicting the future. I sometimes refer to a mature model as a "crystal ball". Keep in mind that accurate modeling is useless unless you are willing to make the hard decisions necessary based on the information and forecasts it provides. Sometimes the model will encourage you to be more aggressive with new hires and marketing, while other times it will warn you to proceed with a slower and more cautious approach.
Any business can have a stellar or down month so avoid making knee jerk decisions, but when a pattern emerges, it is the navigator's job to act decisively. Don't hesitate to downsize if that's what it takes to keep your venture afloat. And don't procrastinate doing what you know needs to be done by saying each month that you can make it up next month. Saying, "We can sell our way out of this" is akin to the proverbial redneck saying, "Watch this". Something bad usually happens next. It's easy to dig a hole that you can't climb out of. As an entrepreneur, your forecast is your best friend, but it is only as good as your commitment to act on it. If the radar tells you there is an iceberg ahead and you ignore the information, then there's no real benefit to having radar in the first place.
I believe that it is very important to develop your business model yourself. Don't hand this task off to your accountant or rented CFO. You need to do this yourself because you need to understand your business, and building this model yourself is the best way for you to accomplish that. It will also empower you to interpret what the model is telling you in the future. If you can't model your business yourself on a computer screen, then there's no way you are going to be able to build it in the real world.
I'll close out this section with a few practical tips to remember when building your model.
First, be conservative. I love how entrepreneurs tend to be optimists. As children, I'm certain that had we been put in pool of horse pooh up to our necks, we simply would have smiled and looked for a pony to ride. Normally optimism is a good thing, but the one occasion when it will work against you is when forecasting. I have found most first-pass revenue models to be overstated by 100%. So if the range for estimated sales is 3 to 7 per month, then use 3 or better yet 2. Being ahead of plan is a wonderful problem to have, but finding yourself overextended and undercapitalized is as horrible psychologically as it is fiscally. You also don't want to set expectations for your investors that aren't realistic. Investment terms often give your investors the rights to take more equity, decline a promised capital call, or even fire you from your own company if you get too far behind plan. So don't hand out big sticks that might be used later on in your beating.
When doing your initial model, keep an open mind. If conservative numbers just don't work, then don't hesitate to walk away from your idea or to radically change the plan. Many great ideas are just not practical, can't be monetized or require more startup capital then you will be able to attract. Success is much more about the entrepreneur than the idea so don't get all emotionally attached to your first love. The model did its job so you can now free up your time and your mind for the next more viable idea.
Second, develop your model on a cash basis rather than an accrual basis. This simply means that when you make a sale, don't recognize the revenue until you have actually received it. Some businesses are credit card based and you get the money at the time of the sales transaction. However others, especially most B2B sales, will be on NET 30 to even NET 60 terms. This leaves you waiting a month or two to get paid. Even if your accounting system is accrual-based, your model should always be cash-based because if you can't make payroll, your employees aren't really going to care that you have lots of theoretical cash on the books. This often means modeling the revenue a month or two after the sale which can make a big difference in how much money you need to raise or keep on hand.
Keep your expense line as minimal as possible. The trappings of business are just distractions that shorten your runway. Unless you are a customer destination center, you don't need fine desks or bookcases. Flex space and folding tables are often more than enough to get you going. A true entrepreneur would trade his or her nice desk any day to fund one additional marketing campaign in those early days. The tremendous amount of used office furniture and equipment available today is testament that most startups don't make it especially the ones with fancy trappings. And whatever you do, avoid those $800 Aeron chairs, even the used ones. I think they might be bad luck because every startup I've ever seen that had even just one ran out money!
Just like those early explorers sailing out into the abyss, you need to be armed with a well conceived plan. Making high risk decisions with limited information is scary and the main reason why the faint of heart don't start companies. However, a well conceived and continuously updated business model will be your precious instrument panel that enables you to navigate your ship through the fog of an uncertain future.
Part 1, The Startup Hats: Introduction
Part 2, The Startup Hats: The Entrepreneur Hat