The first step to building the Financial Projections for a startup company is to build out the revenue model.
The revenue model answers one of the most important questions about a new business: ‘how does it make money?’
The revenue model is important for several reasons:
1. It provides the top-line of the profit and loss statement (total revenue)
2. It also provides gross or operating revenue
3. It allows us to understand marketing, personnel, and operating budgets
4. It helps us to determine the valuation of the company and the potential returns an investor can expect on their investment.
There are several types of revenue models that businesses can choose from.
In this blog post, we’ll discuss some of the most common revenue models.
Before we can chose the best revenue model for the business, we need to understand the cost to produce our product or service (also known as the cost of goods sold or COGS) as well as the price of our product or service.
Determining the Cost of Goods Sold
COGS are the direct costs that relate to the production or purchase of the product or service.
Potential direct costs include:
– Cost to purchase the merchandise for resale
– Cost of raw materials
– Packaging costs
– Cost of inventory of finished products
COGS or direct costs can be thought of as the marginal cost or the added costs of producing one more unit of your product or service. This is opposed to the indirect costs that include labor salaries, equipment used in the manufacturing process, etc.
Determining the Price
When determining the price of your product or service there are several aspects that you need to consider:
– What are my competitors pricing their product or service at?
– What is my target market willing and able to pay?
– What do I need to price this at in order to turn a profit?
There is no right answer or formula for determining the price of your product but by taking the questions above into consideration you should be able to identify a reasonable price for your product or solution.
Determining the Revenue Growth Model
All revenue growth models are created using a growth driver.
A growth driver is a key assumption or set of assumptions that determine the number of units the company will sell.
Below are some of the most common revenue growth models and growth drivers:
1. Sales Growth Model
The sales growth model is the most basic revenue growth model as the growth driver is simply a percent increase on sales every month. For example, we will sell 10,000 units in year 1 growing 50% per year to 22,500 units by year 3.
2. Sales Rep / Distributor Model
The sales rep growth model is best used for companies with a salesforce that is responsible for wholesale or retail sales. There are two key growth drivers for this model: the total number of sales reps and the total number of sales per rep.
3. Website Traffic Model
The website traffic model is used for websites whose revenue is directly tied to the amount of traffic visiting the site. The key growth driver for this model is the rate at which traffic will grow overtime.
Additionally, depending on the type of website (e-commerce or software as a service) additional growth drivers will be important.
For example, for e-commerce sites, you’ll need to convert traffic to purchased items.
Similarly, for software as a service sites, you’ll need to project the free trial conversion rate, paid subscriber conversion rate, and churn rate.
4. Mobile App Download Model
The mobile app download model relies on two key growth drivers: customer acquisition spend and customer acquisition cost. The customer acquisition spend is basically the marketing budget allocated to acquiring new customers through advertisement.
The customer acquisition cost depicts how much it costs to acquire one new customer. If a company has a customer acquisition cost of $1 and they spend $1,000 per month of customer acquisition, they can expect 1,000 new users per month.
Mobile apps often have additional assumptions such as registration rate if the mobile app requires the user to register an account after downloading the app.
5. Online Advertisement Model
Many websites and apps generate revenue through advertisements. The key growth drivers for this model are the number of impressions (which is derived from the number of ads per page and the number of page views) as well as the CPM (cost per million page views).