We’ve all had it happen. One evening, you sit down at your dining room table to write a killer blog post. You fire up your Mac Book Pro, brew some herbal tea, and put WordPress.com into “quiet mode.” With a flurry of keystrokes, you start pounding out nuggets of blogging gold. You spend at least an hour creating graphs and neat little examples to illustrate your points. You pick a funny picture from fail blog to put in the upper-right hand corner. Hilariousness ensues.
All of the sudden, a moment of self-consciousness washes over you: “I wonder if anyone else has written about this before.”
Yeah, someone probably has. @rdhjr tells me Harry Truman once said: “The only new thing in the world is history you don’t know.” That makes me feel a bit better.
In my case, I started writing about building sales-driven financial models, but (alas!) David Skok of Matrix Partners beat me to the punch almost a year ago. His series of blog posts on SaaS Economics (part 1 and part 2) cover the topic in far greater detail than I had intended. (If you want to play along at home, download his excellent spreadsheet here.) What I’ll do instead is draw heavily from his posts and provide an answer to a question I get asked frequently.
How should a startup build its financial model?
My short answer is that costs drive revenues. In other words, costs are the independent variable, while revenues are the dependent variable. In a sales-driven business, specifically, the main revenue drivers should be (1) the size, productivity, and cost of your salesforce and (2) the breadth, quality, and cost of your leads.
To illustrate this concept, look at the “assumptions” section of David’s excel model. It’s primarily driven by the following:
- Compensation of sales account executives (salary + commission + overhead)
- Sales quotas, ramp rates, and attrition
- Cost and mix of lead generation
- Annual contract value and gross margin per deal
Note that only the last bullet has anything to do with revenue. The rest of the model is entirely driven by the cost and productivity of available resources. And, that makes sense. You can think of salespeople like any other investment you make in your business: you spend money on them up-front, and you hope to make an return on that investment (ROI) in the near future.
David shows the ROI on an individual salesperson here:
Hiring a new sales person with this set of assumptions is equivalent to making an investment of roughly $100,000 that pays itself back in 22 months and generates cash thereafter. The annual IRR measured over 36 months on such an investment is 55%, so under most reasonable scenarios I’d view this investment as a very good one.
The aggregate of these curves for your individual sales people is the main component of the cash flow of your business, shown here with 2 different hiring plans:
Once you add line items for marketing, R&D, and G&A, you basically have the last slide of your pitch deck, which tells a VC why you are raising money (to fund the above cash trough). Along the way, you will have created the P&L that you need to include as well.
While I have focused here on sales-driven, recurring revenue businesses, a similar analysis could (and should!) be performed on most other types of internet businesses, including advertising-driven digital media and e-commerce. In all cases, you should set up the financial model so that the revenues are driven by some key cost center that you can measure and control.
Have examples from other types of businesses? Please let me know in the comment section below.