It's time for the final leg in this four part series. After putting together some thoughts on questions entrepreneurs should have for angels (see that post here), I got a number of questions and comments from angels about some counter questions they should ask entrepreneurs in an effort to better analyze the model and company.
In simple, a business model is an integrated array of distinctive choices specifying a startup’s unique customer value proposition and how it will configure activities—including those of its partners—to deliver that value and earn sustainable profits.
These choices startups make can be grouped into FOUR BROAD categories pertaining to a startup’s customer value proposition (see here), technology and operations plan (see here), go-to-market approach (see here), and profit formula .
Profit Formula Analysis of a new venture’s profit formula does not require an entrepreneur to make additional choices about business model design. Rather, this analysis evaluates the venture’s long-term economic viability, based on assumptions about its customer value proposition, technology and operations management, and go-to-market plan. To confirm that these assumptions yield a profitable business, an entrepreneur must answer the following questions:
- What contribution margin (revenue - variable costs/revenue) will the venture earn?
- What will be its unit economics, that is, contribution per unit of product sold?
- What fixed costs will the venture incur?
- What break-even level of capacity utilization and sales volume does this imply?
- What share of the total addressable market does the break-even sales volume represent?
- How much investment in working capital and property, plant equipment will be required per dollar of revenue?
- Can the venture reduce working capital by delaying payments to suppliers? Receiving payments from customers before delivering its product (as with subscriptions)? Shifting inventory to partners?
- How will the venture’s contribution margin, fixed costs, and investment/revenue ratio change as the business scales?
- Given projected growth, what is the profile of the venture’s cash flow curve? In particular, how deep is the curve’s trough, and when will it be reached?
It is useful to analyze a new venture’s economics by following accrual accounting principles for the timing of revenue recognition and the depreciation and amortization of investments. However, for resource-constrained early-stage start-ups, managing cash flow is absolutely crucial. For this reason, when designing business models, most entrepreneurs should put accrual accounting on the back burner—at least at temporarily—and focus on cash flow using this formula, which captures the key metrics in the questions above:
In the formula, TAM = Total Addressable Market, VC = Variable Costs, and FC = Fixed Costs. Projecting the formula above over time—and taking into account any interest payments and taxes—yields the venture’s cash flow curve, which plots cumulative cash flow from operations. The curve reveals the two most important facts that an entrepreneur needs to know about their business model: what is the magnitude of maximum cumulative negative cash flow, and when will that point be reached?