First Steps Consulting – Startup Strategy  

Financial modeling is difficult, but financial modeling for startups can sometimes feel like an exercise in fantasy.  Large corporations who have access to years of historical data, professional financial expertise on staff and access to paid research and data to confirm assumptions still find that models are poor predictors of the future.

Startups are often operating in disruptive markets where there is little supporting historical data, and a great deal of ambiguity about future inputs that could impact the projections.

Given this context, how do we best define our financial potential?  What is the main objective of financial modeling for startups? To answer this question, lets look at the two main components of any financial projection and how they are influenced by startup status

The Inputs

The driving force behind any financial projections are which bits of data we choose to drive the model, and the quality of the data that we input.  At a moment in time, inputs will define our cost structure and revenue potential, and then there will be inputs that define growth over time and scale.

As a startup your knowledge of your cost structure and revenue potential over time and at scale is quite fuzzy primarily because your knowledge of potential growth is difficult to predict.  The biggest mistake made in projections for startups is the masking of business model flaws by “scaling” a startup to profitability.

Essentially, the most accurate snapshot of a startup’s potential exists at the unit level rather than the aggregate.  Most investors know this, and are most attracted to startups that can generate significant value per unit.  The one exception to this are truly disruptive innovations that are market changers, but there are not too many of those so the starting expectation is unit level value.

The Outputs

The outputs that typical projections produce range from predictions of profitability, revenue growth, equity growth and cash on hand.  Again, the number of unknown variables for startups makes it difficult to project most of these.  Profitability typically relies on time and scale assumptions again (as most startups are not profitable in the first three years) and equity growth assumes knowledge around capital needs and access to capital during startup that is hard to predict.

The output that really matters to startups is cash.  Cash on hand predictions for startups are accurate and critical to growth and survival on a month to month basis from day one.  No one cares about profitability or equity value in Year 5 if you can’t maintain enough liquidity to get there.  Investors want to know your Free Cash Flow, Burn Rate and OOC (out of cash) predictions.

So what connects these two insights?…Unit Contributin Margin

Formally defined, Unit Contribution Margin is Unit Revenue minus Unit Variable Cost.  Before going any further, I want to take a moment to note that contribution margin is not the same as Gross Margin. There is a wealth of misinformation about this online. Contribution Margin separates out variable costs, which it includes in its calculation, from fixed costs, which it doesn’t include in its calculation. Gross margin is total revenue minus the cost of good sold.  The cost of goods sold is not exclusively a fixed or variable cost.

Cost of goods sold could include a portion of fixed overhead costs, and in some cases may not include some of the variable costs that are not directly associated with the cost of production (ie. variable administrative costs)

Because Contribution Margin strictly separates out fixed and variable costs, it provides a more accurate benchmark for how much leverage can be acheived by scaling up sales.   In essence, as long as your Contribution Margin is positive, it makes sense to scale up sales because each sale is contributing to covering the base of fixed costs.  If your contribution margin is negative, then you need to find another line of business or change the business model.

Maybe you are not starting to see why this is so appealing to investors.  If I want to invest $500K into a business, I want to know that my dollars are going to provide maximum leverage in driving a business to breakeven.  I want to know that each unit sale is throwing off cash to cover fixed investments. The more cash each unit sale is throwing off, the quicker I reach breakeven, the smaller my Burn Rate and the longer until OOC.

The hardest part of calculating contribution margin, is properly identifying the “variable costs”.  At its simplest, variable costs are those costs that are directly connected to a sale of a unit.  The most obvious of these is the cost of good sold, but it also important to identify other variable costs that are not so straightforward.  For example, some portion of marketing expense may be variable.  If you have a pay per action advertising campaign, or if you can link the number of unit sales to a larger marketing campaign, the cost attributed to each sale could be defined as variable.  Another example is sales commission paid that is linked to sales volume or even variable production costs.

To explore this further, take a look at this submission on management accounting.

Unit Contribution Margin is not a replacement for a complete financial model, but it is a quick way to get a snapshot of your financial potential before you invest the time and commitment required to develop a full  model and validate its assumptions.

Check out our flash based dashboard for quick Contribution Margin calculations by clicking on the image below.

This is a Startup Consulting article by First Steps Consulting