Figuring Out the “Money Machine”

Especially in this challenging fund raising environment, when companies set off to seek the next (or even first) round of financing, it is critical to effectively prove out their business case to investors.  An entrepreneur must prove out the basic mechanics of the “money machine” or economic engine of their business (even if only in pieces) and put in place the building blocks of the long term business model.

To oversimplify the framework – the money machine has a handful of different components: the cost of making and delivering the product (cost of goods sold), new product development and support (research and development) and customer acquisition (sales and marketing). For the purpose of this analysis we will leave out G&A or the fixed general and administrative expenses, which would appear as separate components of the income statement.

• Cost of goods sold should be easily understood and fully loaded (allocated with all costs) for all of the direct costs.  Included in cost of sales are the cost of the product (whether physical materials that are part of a storage box or incremental copy of software), the delivery of the product (for example, hosting), and certain other costs (for example, the cost of payment processing) including any cost of third party services (cost of shipping, customization of software, etc).  At scale, good target margins for software and emerging media (content) companies are 80%+ and services companies are 50%.  Fortunately, most software and emerging media businesses have a very high gross margin given their low marginal cost of each incremental item or instance.

• New Product Development and Support (R&D) includes the cost of engineers that do not only make your product sell today but also ensure that you have an evolving / leading product in the future.   You can’t cut engineers today assuming a perfect (that needs no further feature or functionality) product and expect revenue to grow.

• Customer Acquisition (Sales and Marketing) includes both people and any customer acquisition – primarily direct response marketing or direct sales people.   In this era of online advertising and sales funnel management tools, the company should be able to track total customer acquisition expense very simply both on an aggregate and individual traction basis.  Additionally, company will higher margins or who have line of business with higher gross margins can afford higher sales and marketing costs.

When we know the contribution margin, you figure out what you are willing to spend on customer acquisition (leaving lifetime customer value and repeat usage aside).  In this model, if you spend $1 on customer acquisition and drive $2 (or even $1.10) of incremental contribution margin — your world suddenly changes!

Once you figure out the money machine, not only does your business become easier to manage and more automated, but fundraising becomes easier … if even necessary at all.   Who wouldn’t want to invest $1 to get $2 back?

Everyone understands that this is easier said than done, but the goal is to figure out parts of the money machine to maintain better control on the business (including capital allocation) but further puts you on the road to self-sufficiency and profitability – the holy grail!

						At Scale Business Model Goals
						Software	Hardware	Services
	Revenue					100%	100%	100%
	Cost of Sales (Direct Costs)					20%	40%	60%
	Gross Profit					80%	60%	40%
	Operating Expenses
		Sales and Marketing (Customer Acquisition)				25%	20%	15%
		Research and Development				20%	15%	5%
		General and Administrative				10%	10%	10%
	Total Operating Expenses					55%	45%	30%
	Contribution Margin					25%	15%	10%

Ranking the Entrepreneurs That I‘d Want as Partners

The process of making venture investments is an odd mating dance.  Entrepreneurs and investors spend weeks or months attempting to make a critical decision – can they partner together to build a lasting business?

Making or taking an investment is committing to a long term partnership.  Like all relationships – there will be good times and bad, and countless issues to work through.   I have seen thousands of entrepreneurs with a wide range of skill sets be both successful and unsuccessful – and the reality is, there is no silver bullet.  In addition to other components (integrity, a history of winning, experience, etc), I look their passion’s driving force with the goal of understanding why they are launching the business.

The founders’ drive and motivations sets the company’s culture.  Passion-driven founders find that the passion is contagious and hire similar folks.   Mercenary founders often hire other mercenaries which are often talented but driven primarily by the ultimate financial reward.   These differences manifest themselves in the overarching firm culture (coming post) and tactical ways such as having to pay more and higher recruitment fees.

Over the years, I have seen these general motivations, along a continuum, in ranked order -

• Pure Passion:  The entrepreneur has been obsessed with the industry, business and the idea for a long time.  If they do not pursue this idea – it will kill them.   These entrepreneurs have a singular focus on the vision prize – usually to the detriment of everything else in their life.   Not following their passion is simply not an option.   The culture creates energy and you can feel the buzz as you walk in the door.
• Amazing Opportunity:  He or she started the company, customers started buying, and the market opened up.  All of a sudden the entrepreneur realizes they have stumbled on a fantastic opportunity.  They might not have thought they would have been in the widget color-coding software business but the business opportunity is interesting, compelling and financially rewarding.
• Big Carrot (Huge Challenge or Financial Reward): The entrepreneur views the business as a huge challenge (incidentally, a tremendous driver for type-A personalities and ego-driven entrepreneurs).  There may also be a huge financial reward and they will work hard to achieve the dollars or the trophy.    
• Duty:  The entrepreneur feels a moral obligation to their co-founders, investors or members of the management team to do their best to drive toward a good liquidity event.
• Paycheck:  He or she needs a job and a paycheck – a particularly scary.   Normally, this happens over time with a company that might have lost their way and missed milestones and everyone is just trying not to get laid off or have the company shut down.

After a decade in venture capital, my “blink test” on founders doesn’t always work, not many founders fit clearly in a single bucket and this continuum does not perfectly correlate to successful outcomes, but this sets a good framework, increases the chance of success and makes the process a lot more enjoyable!