What is Your Financial Model?
In the July issue of CATALYST, I discussed the notion of a financial signature, which is essentially the way that an individual is wired from a financial standpoint and why it is important to match the individual’s nature with the company’s leadership needs. This month I am going to discuss a very different concept with a similar sounding name: a financial model.
Having a coherent and viable financial model is critical to the success of every enterprise, even for a non-profit. Any company that has survived for several years has a financial model, whether the owners realize it or not.
Often the financial model is not strictly adhered to, nor is it not optimally crafted, and the company underperforms its financial potential as a result. Worse yet, many early-stage companies lack a financial model altogether, which is why most creative ideas never lead to commercially viable enterprises.
In its simplest form, a financial model is the mathematical formula explaining how a company makes money (or in the case of a not-for-profit, funds itself.) While that sounds like a very rudimentary concept, most early-stage companies that are unable to raise capital face this dilemma because they have not articulated exactly how they will make an appropriate return on the funds they are seeking.
And many mature companies perform well below their potential because they do not understand their financial model, or they have allowed themselves to drift from their financial model to pursue opportunistic ventures or markets that looked like an easy way to make a buck.
Often when a company starts out, the owner(s) discover their financial model through trial and error. They begin selling a product or service and feel their way through the cash flow minefields until they develop a formula for profitability. But it is best to not only establish such a formula before investing dollar one in a venture, the CEO of the company should constantly evaluate alternative financial models and pursue a strategy consistent with the most lucrative model.
I have been approached by many entrepreneurs over the years who had developed an innovative product, service or technology and were in search of capital to launch a new business. One such entrepreneur had a compelling home wastewater treatment product that he had spent several years and hundreds of thousands of dollars developing. But when I asked him some simple questions such as:
How much will it cost to produce the product?
What price will the product command in the marketplace given alternative solutions?
What kind of infrastructure will be required to produce and sell the product as well as manage the company, and how much will it cost?
How many units need to be sold at the profit margins assumed in the first two questions to pay for the costs in question three?
Is it reasonable to assume you can sell that many units, and how long will it take you to achieve that volume?
How much cash will you burn through in the meantime getting to your breakeven point?
What is a reasonable ultimate goal for unit sales, and how much money will you make if you achieve that level?
He had answers to none of the above.
Answering these questions will force a business owner/CEO to establish a financial model. And without some very carefully researched and articulated answers to all these questions, you have no prayer of raising venture capital.
But often even companies that have been around for a long time lack a viable financial model. I speak to groups of business owners around the country several times a month about business valuation and exit strategies. In just about every group there is at least one business owner who has built a large recognizable business that has tens of millions of dollars in revenues and dozens to hundreds of employees that has no clue what their financial model is; the owner is growing a company that generates little residual cash flow and has essentially no value.
This is common among engineering and construction firms. The emphasis is on growth…building more buildings, being retained by more clients, hiring larger staffs. But at the end of the day, the company makes no money. Growth is not a financial model. There is often little correlation between size and value. For example, AirTran Airways is worth more than Delta Air Lines..
The financial models at many companies are not always obvious. General Motors may have boosted car sales with its “employee pricing” promotion. But the more cars GM sold, the more money it lost, which produced a wave of negative press. Why would they do this? GM’s unstated financial model is not to make money on selling cars. It is to make money financing cars.
Unfortunately, GM hasn’t done a very good job making money on anything lately.
Gillette is a company whose financial model is legend. Its model was: who cares if you make any money selling razors, just sell as many as you can. Then price the razor blades so that the profit margins are extravagant. Likewise, Hewlett Packard produces the best copy and fax machines in the market for the price, but HP makes most of its money selling toner, not printers.
Take, for example, the magazine in your hands at the moment. Many people believe that a magazine publisher generates revenues primarily from selling subscriptions. This financial model would doom most publications. Leader Publishing’s financial model is under-girded by two primary revenue sources, neither of which is subscription fees. Advertisers who buy space in these type publications generate much more revenues than subscribers, and advertisers pay higher fees to place ads in magazines with larger circulations. An advertising based financial model leads to a very different strategy than a subscriber based revenue model.
Moreover, given the target market of CATALYST, Business to Business and Atlanta Woman, Leader has adroitly targeted the market for events such as breakfasts with speakers and seminars on specific business topics. So is the magazine’s role to support the events, or do the events support the magazine? Where is money made, and what investments are required to perpetuate the financial model? These are the sort of questions every business owner should ask.
My firm has a financial model that is unique in the M&A world. Our primary revenue source is helping business owners transition the ownership of their companies by selling them to strategic buyers, private equity firms or ESOPs. However, most people think of us as a business valuation firm. The truth is that we use the valuation service to establish relationships with business owners before they are ready to sell.
But since you can’t make what I consider to be good money doing valuation work, we developed proprietary software to minimize the man-hours required to produce a quality valuation report. That way we can do a lot of valuations each year without getting bogged down in a low-return business. Yet in years when the M&A market is poor, we have a stable revenue base to pay the overhead, so we can survive the downturns, unlike most boutique M&A firms.
Your financial model should give you a specific roadmap for how to operate your business. But it only works if you keep the truck on the road. It is tempting to take on any client that is capable of paying fees, or to sell to any customer that is willing to purchase your product, but it is very easy to get distracted and end up with business economics very different from where you started.
Most important of all, make sure you are not on a dead end road. Your financial model should produce cash flows for the company that provide a return greater than what you could achieve investing your money elsewhere.
Growth alone easily deludes far too many business owners into thinking they are getting somewhere, when they are merely treading water. An effective financial model is one where there is significant residual cash flow so that the owners achieve a handsome return beyond just a paycheck.
Michael Jacobs, Author
Michael Jacobs is the CEO of Jacobs Capital and Professor of the Practice of Finance at The University of North Carolina at Chapel Hill. He's the author of several books and a certified speaker.
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