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|
|Cost of Sales (Direct Costs)||20%||40%||60%|
|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%|