Startup infrastructure: Revenue model

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Startup revenue model (Excel.xls download)

Customer conversion model (PowerPoint.ppt download)

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The revenue model is the keystone of the business model.  It goes in last but holds the entire structure together.

Like all things startup, your revenue model is nothing more than a hypothesis to be tested.  Start right and you’ll have more focused product and customer development and stronger engagement in the capital raise.

Here’s how to do it.

1. Price x Volume = Revenue.  That equation gives your base.  Wait until you know roughly where you’re aiming the business, then grab your team, head to a white board and start answering basic questions.  Who is our target customer?  What is our product or service solution?  How much can we charge?  Who pays, our users or someone else (such as advertisers)?  What units drive revenues (clicks, page views, downloads, widgets shipped)? How many units are feasible?

2. How does volume scale?  Still at the white board, start exploring feasible volume growth dynamics across time.  By month, at what pace can you increase unit sales?  What are the limits?  What’s the total market?  What segment of the market do you address?  How much share can you keep or take?

3. “What are the physics?”  Specifically, what are the physical customer touch points through which you’ll directly reach target customers?  That’s the best question I’ve been asked about crafting a revenue model.  No surprise since it came from Lyle Wallis, President of Decisio, which gives big companies a bit of a crystal ball on how to optimally launch products and services like GM’s OnStar.  The action here is to brainstorm the ways you’ll reach customers and they’ll reach you.  Radio ads?  Direct sales calls?  TV spots?  Banner ads and Google AdWords? Referral?  Search?  Customers walking in a physical door?  List the possibilities then bring it down to a short list of the best.

4. Visually connect.  Now put it together visually.  Draw on the board your target customers, your channels for reaching them, and what happens between first touch and revenue.  It’s often helpful to reduce this to PowerPoint for future discussions, both internal and with VCs.   The PowerPoint linked at top is Qbillion’s, with credit to Dave McClure whose brilliant “Startup Metrics for Pirates” pointed me down the right path.

5. Model the math.  Finally, convert the logical flow into formulas in a spreadsheet.  Just follow the logic you’ve already sketched out.  You’ll find that modeling in a spreadsheet dramatically tightens your business thinking.  Your aim is to capture how physical activities drive customer actions and at what rates.  For example, translated from Excel to English, a good revenue model may say,

For every $100 we spend on Google AdWords, we’ll gain I impressions and C clicks.  A percent of those who click will abandon within 30 seconds.  Of those not abandoning, H percent will have a happy first visit and S percent will sign up for our messaging.  U percent will become active users and P percent will become paying customers.  We’ll lose X percent per month to churn.” 

Contrast that bottom-up logic with rookie top-down logic of, “We’re in a $15 billion market and have such a great product we can conservatively take 35% share within three years, and will thus have over $5 billion in revenue.“  Which path gives you actionable detail to test, learn from and improve?  Which impresses a VC with your business thinking?  Embedded above is an Excel revenue model I created for Qbillion (assumptions generalized for confidentiality).  It reflects a freemium type revenue model of free base usage and subscription premium usage, with plumbing for an ad revenue model included but zeroed.  The PowerPoint and Excel files are a revenue model partnership of the visual and the mathematical, both saying the same thing in a different medium.

Conclusion:  You’re not going to precisely nail the numbers, but that’s not the point.  What’s critical is that you become more directionally right with each iteration.  It’s about learning what channels work, what your true channel costs are, how to trade off and optimize those costs, how to increase customer referral activity and the impact this has on revenue and profits, etc.  With a good revenue model crafted, you’ve taken a leap towards being a learning organization that tests business model hypotheses, improves, and ultimately succeeds.

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