Developing a revenue model for your business is perhaps the best way to get and keep your startup financially healthy. A well thought out and credible revenue model connects the dots for potential investors.
How do you go about creating a solid revenue model? First, you need to figure out what revenues you can expect to generate. Even if you’re still at the pre-revenue stage, you should build a financial model that includes your revenue estimates. Financial forecasting can be done in one of two ways: projecting your numbers from the top-down or building your projections from the bottom-up.
Top-down forecasting definitely won’t generate realistic figures but is still important to show investors when you are raising money. Top-down forecasting starts with estimating total market size and then gauging the size of your target niche within that market. From there, you estimate the share you will capture at a ballpark figure for your revenue potential.
The better approach is to do a bottom-up projection. To do this, first decide which indicators will have the greatest impact on your revenue over the next year or so. Next, figure out how much you need to spend to reach your revenue and development targets and what your key revenue drivers are. This will give you a sense of how fast you can scale incorporating levels of staffing and upcoming milestones.
We’ve helped many clients through the process of developing their business revenue models. Based on our experience, here are the seven key considerations for creating an effective model:
1. Find the right fit for startup and expertise
You may have a strong technology model with business-savvy engineers on staff. You may also know what research and development stage you are in and where you are heading. Use that knowledge to determine which revenue model works best for you.
Your revenue projections might need to be linear or exponential depending on your type of business. You might need to build to scale to prove your revenue model or first create a smaller model to reduce capital risk and then scale. The best model is the one that supports your development efforts.
2. Create a framework for expressing value
What differentiates your products and services from the competition? Your revenue model should communicate your unique value proposition. For instance, offering a distinctive service that people will sign up for is a unique a selling point.
3. Build a revenue model that helps you find the right investors
You can strengthen your pitch by making development choices that show investors that you are worth investing in. Be strategic: focus your attention on finding investors who are a good cultural fit and will be in it for the long haul. Pick investors who have the patience to wait in order to realize long-term returns.
4. Limit projections to a reasonable timeframe
Investors will ask you when they can expect their investment to start paying off. They will want to know what your short and long-term milestones are. They will also want to know when you expect to become cash flow positive. Financial projections you use to pitch investors often derive from your revenue model.
It’s tempting to project revenues many years out, but much like trying to predict the weather, if you go too far out your predictions become unreliable. Keep your projections to a 12- to 24-month time frame.
5. Your revenue model is not static
Over time, your model is likely to change even if your general approach remains the same. And the choice of model is up to you. As a service-based company, for instance, you could offer subscriptions or on a one-to-one basis. Don’t paint yourself into a corner by sticking to just one setup. If the model no longer reflects your business realities, adjust it and update your forecast accordingly.
6. Determine the critical variables that drive your business
The variables that matter most for your company will change along with the stage of your business. But regardless of stage, look for the variables that most impact your revenue. Make sure that you define discrete variables so you can address them individually. Assess the inputs and research baseline values for each variable so you can track performance over time. A great way to isolate variables and view how each affect revenue is to chart them out on a sensitivity graph. This will show how changes affect them and resulting impact on your revenue.
7. Mitigate for variables
Risk management starts with identifying and understanding your key risk factors so you can address them. Don’t try to sweep things under the rug—investors will discover your secrets anyway. Mitigating for variables increases transparency, builds confidence, and enhances understanding—both for you and for your investors.
There are lots of options when it comes to revenue models. But not choosing isn’t one of them. It’s a precondition for startup success.