Business model financial viability 2013

Innovation, Entrepreneurship & Design Toolbox

© Imperial College Business School

Financial viability of a business model

• Early assessment tool /process to test

the financial viability of a business

model

• Key outputs include pricing and

volume: what do I have to do to cover

costs and achieve breakeven

(profitability)?

• The introduction of “risk” as a financial

concept: Do the returns compensate

for the risks I am taking as an

entrepreneur?

• Provides early indication whether

outside investment might be needed to

get to breakeven


Assessing financial viability early – What’s this?

‘Sometimes there

is a gap in the

market because

there’s no market

in the gap’

—Irene Bejenke-Walsh

MessageLab

http://www.messagelab.co.uk/

To really be feasible, a business model must make sense

– not just strategically

(where you have a compelling and competitive product

offering and route to market),

– but also financially

(so that you will earn more than you invest!)

– This also makes sense for a social/non-profit enterprise –

you still need to break even!


Why?

• Comes before and informs

both the full market testing and

the full financial projections

• Prompt for entrepreneur to

adopt an investor mind-set

• Qualify & quantify financial

objectives and priorities early

in the process

• Assess early whether

changes to the business

model will be needed.


Why now ?

Financial viability has different parameters depending on

whether you intend to enter:

1. A market for products

• making/selling products to customers

2. A market for technology

• Licensing

• Building then selling a tech company before reaching revenue

Your choice of market might even depend on the respective

financial viability of each option.


Two paths...

1. Market for Products

Is there a ‘market in the gap’?


This section was co-authored by Irene Bejenke Walsh, MessageLab

http://www.messagelab.co.uk/

If you aim to pursue a route to the Market for Products

(see ‘Clarysse model’ in Teece analysis slides in

Business Model tool)


1. Product Market

1. Value Proposition based on Product Offer

(or standardised service)

•Specific product / market niche

•Control over the value chain

•Diverse founding team with experience in industry

•Funding from founders’ own capital, debt or possibly

an Angel, followed by early revenues

-> Revenue Growth by selling standardised products to

customer segments


Key questions to address

• Do the returns on

investment compensate

for the financial risks

involved?

• Can I make a product/

deliver a service which is

competitive on a

breakeven basis ?entr

epre

neur

busin

ess

• Is the addressable

market big enough to

make commercial sense?

(See Entrepreneurial

Market Research in IE&D

Toolbox)

mark

et • How long before the

business is self-financing

and hence…..

• …will I need outside

finance ?

finance

• Addressable market: this needs to be big enough, offer enough potential customers/revenues to make the company scalable (See also “Entrepreneurial Market Research” in IE&D Toolbox)

• A viable business model would satisfy all 3 components opposite

• “Return on investment” is used here as a conceptual term for a number of key financial issues entrepreneurs have to consider in the start-up phase, e.g. cash and time they are investing themselves, and how they want to be compensated for their investment.


The 3 Components of a

“Market in the Gap” Analysis

Market scale

Breakeven analysis

Return on investment


Breakeven Analysis

This is a rough test to work out how much we need to charge for our product

or service (i.e. the lowest price) in order to at least cover our costs, i.e. get to

breakeven.

•Once we have determined a breakeven price for our product or service, making a few basic

volume and cost assumptions, we can answer the question: is our ‘breakeven price’

competitive in the market?

•If my breakeven price is already higher than that of the nearest existing competitor(s), we are

facing a competitive and financial challenge with different potential outcomes (or a negative

business case). The idea is that the business model has to stand up at a minimum to this

simplified P&L model to assess financial viability.

•This is an interactive process, e.g. a negative business case result may cause us to review

our assumptions and thus produce a new/ lower breakeven price.

•Depending on our funding, we may be able to tolerate a negative business case in Year 1

provided we are confident that the cost base will improve in the near term (also known as ‘cost

leverage’) – this is then an issue for a more detailed financial modelling exercise to determine

when breakeven occurs and how viable this is for us.


Cost analysis

Fixed Variable

Explanation Costs that are the same

regardless of how many

items/ services you sell –

sometimes described as the

costs you need to incur

before you are able to sell

Recurring costs that you need

to pay with each unit you sell –

naturally for some cost items

(eg raw materials), the per unit

cost will depend on volume

Example Development costs,

property costs, marketing,

IT costs, finance costs

(though this depends on

how the business is

financed - debt or founders’

equity)

Cost of raw materials,

distribution costs, product-

based labour/ staff costs,

royalties


Breakeven Analysis - Example

• Our business idea is to make a new digital eco mousetrap, the

E-trap. Its USP is that it humanely contains rather than kills the

mouse, sending out a digital signal upon capture.

• Competitive products, none of which have our USP, are priced

between £2 and £5.

• We have decided we need to pay salaries, including our own, of

between £100k and £120k per annum (note we may choose not

to pay ourselves and effectively contribute our time at this stage).

• What is our breakeven price under various volume assumptions

and is it competitive ?

‘E-trap’ Cost Item Year 1

100 vol

case

GBP’ 000s

Year 1

1000 vol

case

GBP’ 000s

Fixed costs Founder

salaries

100 120

Marketing 50 50

Variable

costs

Raw

material

costs

300 600

Product-

based

labour

costs

50 80

Distribution

costs

100 150

Total Costs 600 1000

Breakeven Revenues 600 1000

Breakeven Pricing 6 1


Breakeven Analysis – Rough P/L

• We have produced a rough profit and loss

for the first year (opposite) comparing two

annual volume assumptions (100 and

1000 units).

• Variable costs - We have sourced

component suppliers and distributors and

costed these on various volume

assumptions – e.g. £450,000 on

assumption of 100 units sold.

• Fixed costs - We have made some

assumptions as to our ‘required’ salaries

and marketing costs – e.g. £830,000 on

assumption of 1000 units sold.

• In our example, our breakeven price per

E-Trap is thus between £1-6 based on

volume assumptions between 100 and

1000 units sold.


Breakeven Analysis – Breakeven prices

and market

• In our example, our derived breakeven prices

of between £1 - £6 compares with a range of

£2 – £5 in the market for existing mousetraps.

• We now repeat this exercise for various

volume assumptions.

• The chart opposite shows a plot of breakeven

prices at various eco mousetrap volumes in

year 1 (includes points A and B giving

breakeven at prices of £1 and £6 as set out

above) with an overlay showing competitive

pricing.

• Conclusion (1): Our product is competitive

on a pure pricing basis if we can sell more

than 500 E-traps (in Year 1).

• Conclusion (2): We may decide that our

product will justify a pricing premium given

its USP. This would cause us to re-calculate

and result in a lower breakeven volume. Breakeven prices

Pro

duct

volu

me

Competitionprice points £2 - £5

100

1000

1 6

500

2 5

A

B

Later, when you go into more extensive Financial Planning,

you will look more carefully at whether you can achieve the

criteria for breakeven by considering the sales cycle and likely

time needed to get a first customer and to sell each unit of

product

– Assess these assumptions in your Market Testing (IE&D Toolbox)

– for B2B, see Sales Plan tool in Roadmap slides in the IE&D Toolbox

For now, it is useful to have an idea at the start of what the

tolerable parameters are.


Can we achieve those criteria?


Quantifying your risk & investment

• Calculating risk and investment as an

entrepreneur are essentially subjective

exercises.

• Two parameters to consider at this early stage

are money and time invested and how you

want to be compensated for these.

• Money: how much cash have I invested in the

business, when do I want/need the money

back and at what return? If I have re-

mortgaged my house and invested £50K,

personal finances might be tight and I will need

a certain level of return to pay for the cost of

finance.

• Time: How long will it take to get to breakeven

point? How long can I go without a salary? If I

have invested in “sweat equity”, i.e. unpaid

time, how much is it worth and how much do I

need/want to earn?

return

venture/ risk

investment

Note: typically, third-party investors require at least a 25% rate of return to invest in a start up business, this means that a business has to return 3x the original investment over 5 years.

• All businesses involve risk and some

businesses are riskier than others.

• Higher risks are acceptable provided they

bring the prospect of higher financial returns.

• At one level, a founder is an investor:

someone who invests his or her own time

and/or money in a new business idea or

venture.

• A venture is only viable , if it compensates

the founder for the risks incurred, i.e…

• …if the founder’s return on investment

exceeds the risks involved.

• For these purposes, the return in a venture

and payback over time could be expressed

as the equivalent annual interest rate you

would receive on the same amount of

money invested over the life of the venture


The concept of return on investment

Question: would you expect to get back more money from a £100 investment in a business start-up or a £100 deposit in a domestic bank account?

Now ask yourself why ?


Risk & return - market rates

Expected Return level

%

Risk level/Company

stage

0 – 5% No/ low risk, e.g. bank

accounts

5 – 15% Mature businesses/

quoted companies

15% - 25% Early stage businesses/

unquoted companies/

higher risk quoted

companies/

25% plus Unquoted start up

businesses

• Risks can be characterised

as the extent to which you

are willing to forego more

certain returns?/ ie how

much money are you

prepared to risk or lose?

• Measuring risk is

subjective, but market

comparisons and

benchmark returns exist

• New business ventures will

tend to fall in the final

category

•Even if we have a competitive product from a breakeven analysis perspective, do the returns compensate us for the risks we’ve taken as founder/ investor ?

•What constitutes an ‘acceptable’ return is influenced by: • the financing structure of the business (capital investment,

cost of finance)

• the nature of the business model (how much could you lose?)

• and the entrepreneur’s own circumstances (how long can I wait for a payback?)


Risk & return - summary


Possible outcomes

Market

scale

Breakeven

analysis

Return on

investment

Comment

No Addressable market too small

Yes No No Big enough market, but chosen product not

cost effective and hence poor return on

investment

Yes Yes No Big enough market, competitive product,

but limited expansion (or premium product)

opportunities limit financial returns

Yes No Yes Big enough market, but product not

competitive in early years

Yes Yes Yes Big enough market, competitive product

and appropriate financial returns :

‘market in the gap’


Improving the gap – possible changes

Failed on Operational change Financing change

Market scale Consider other

complementary niche

markets

n/a

Breakeven analysis Change the cost

structure (new route to

market, leasing key

assets, cut salaries,

staged launch).

Consider adding

complementary product

line

Change financing

structure (financial

investor/ strategic

investor) so you can

tolerate early stage

losses for longer

Return on investment As above and consider

a faster roll out

Introduce more debt

and/or equity investor

2. Market for Technology


If you assess an IP licensing business

model, financial viability analysis is

similar to that for products

In other words, assess

1. your addressable market size:

– For what applications could you

license? Which industries would be

most interested? (T/A Matrix in IE&D

Toolbox)

– How big is the addressable market?

(Entrepreneurial Market Research)

(e.g. ask ‘preferred witnesses‘)


2. Technology market – IP licensing

Market scale

Breakeven analysis


2. Your breakeven prospects

– What are licensing fees for comparable

technologies (pricing)?

– What are the legal/IP protection costs?

(could be high) (again, ask ‘preferred witnesses’)

– Licensing is not a labour intensive

activity;

» How can you keep overheads low to

maximise profit?

– But licensing fees are usually not huge;

» What volume of business is needed to

reach breakeven/profit?


IP Licensing business, continued...

Market scale

Breakeven analysis


3. and your risk/return

profile.

• How much time/money needed

to reach that volume (acquire

licensing customers)?

» And how much are you

willing to invest yourself

and wait before payback?

» Would you likely need to

raise external capital?


IP licensing, cont...

Market scale

Breakeven analysis


If you are considering the route to the market for Technology

via a trade sale rather than revenue (See ‘Clarysse model’ in Teece analysis slides in Business Model

tool)


2. Technology market – building toward a

trade sale

1. Look at acquisition prices of comparable companies

2. Assess the stage of development those companies had

reached when they were acquired

3. Assess what market conditions were like at the time

4. Estimate the potential value of your business at similar

stages and market conditions

5. Evaluate the return on the effort and investment needed


Technology business model – financial

viability

1. Look at comparable companies (similar industry/market)

where early investors exited via a trade sale pre-revenue• What was the acquisition price?

2. At what stage of development was the comparable company

when it achieved that price? e.g.: • Med/biotech: It had passed a stage 2 trial, or it had undergone full clinical trials

• Engineering: It had achieved a certain stage of advanced prototype or pilot tests;

it had built a certain amount of infrastructure

• Digital: it had a certain size of user base, a proven user growth trend, etc.

• And generally: employee headcount, size of technical team, size of general

operations, number of years the company has existed, etc.

Typically, at a more advanced stage of development >>

greater acquisition price


Look at comparables – Steps 1 and 2

You might try to extrapolate a value per asset ‘unit’ at

those comparable companies, based on acquisition value

E.g.• Value per registered free user/paying customer (website)

• Value per unit of infrastructure built (engineering)

• Value of successful trial (medical), etc.

In other words, find a basis for comparison with your business


2. Stage of development - value

3. What were financial market conditions like (esp. for private

equity deals) at the time the comparable companies were

acquired?

• Greater risk appetite among investors >> greater price

• Depressed financial market >> lower price

– How much competition was there on the market?

• Was it a trendy sector? Investors trying to play catch-up to get into

the market >> price rises

• Were there a lot of competing companies seeking acquisition?

>>price may fall

In short, what factors (stage of development and market)

drove exit valuation at comparable companies?


Look at Comparables - 3. Market conditions

4. Estimate the potential value of your business at similar

stages and market conditions

• How long might it take you to achieve a comparable stage of

development to previously acquired companies, or comparable

milestones?

What could your ‘value per unit’ be at that stage?

• Consider possible business value in a buoyant or depressed

market .

The above will be speculative, but can offer a starting point

for considering a future value range (depending on

conditions).


Comparables and you – step 4

What kind of investment (£) would be needed for the co. to

reach a ‘sellable’ stage? How much work?• Develop Management team, Tech team, general staff

• Infrastructure

• Achieving regulatory compliance

• etc.

Given the cost, time and risk, would the final payoff (sale)

reward you sufficiently?• For the entrepreneur this may be subjective

• For a financial investor less so – typically seek a 50-60% annual return

or 10 times initial investment

• e.g. Imperial Innovations aims for exit sales of at least £100 million,

besides a high return on initial investment


5. Is the business model worth the

investment?

• An idea for a business model may be compelling from a

strategic point of view

• ...but it also has to pass financial muster

• This is true whether you are aiming to start a profitable

business or a social/non-profit activity, which must still

break-even

• A financial viability exercise may also be a deciding factor

in your choice between the market for products or the

market for technology


Conclusion

Clarysse, B. and Kiefer, S., 2011. The Smart Entrepreneur.

London: Elliot & Thompson, Ch. 7, 9 & 12.


Further Reading

Economy & Finance

Business model financial viability 2013