I see a lot of business plans throughout the year. Over time I have learned to skip the executive summary and go straight to the model. Business models tell you a lot about the plan and how well thought out it is. And herein lies the rub for many first time enterpreneurs.
I hope you enjoy this third installment in my Startup blarticle series...
Why Every Entrepreneur Should Play Sudoku
At the end of last year, I went home to visit my mother (yes, I know, how sweet of me). I still maintain when talking to her that it was purely coincidental that my grandparents were in town from the U.K. All Robertson family gatherings basically follow the same game plan: wake up, eat, discuss where to have lunch, drive to decided location, eat, discuss where to have a post-prandial latte, ignore all suggestions and end up going to the Lodge at Pebble Beach, discuss what to have for dinner, eat, play Boggle, give up in despair as Niel always wins, discuss when to have breakfast, go to bed. Rinse and repeat. Like clockwork. Every once and a while we’ll toss in a brisk walk along the beach in Carmel if we’re feeling frisky. Trust me, this isn’t a complaint at all. It’s my version of “mom and apple pie” and I love it.
One night during my most recent visit, we opted to skip the Boggle and entertain ourselves with more promising endeavors. After a few minutes fighting to get interested in a book I was reading, I noticed my Grandfather scribbling madly in a little paperback book. Curiosity (and waning interest in my book) got the better of me. It turns out that Grandfather had been bitten by the Sudoku bug. For those of you not familiar with this cultural phenomenon, Sudoku is a Japanese number game that is quickly overtaking your Sunday crossword puzzle section. If you see something like this in the corner of page 12, you’ve encountered Sudoku:
The rules of the
game are simple:
- Each row must have the numbers 1–9 in it, but they can only appear once
- Each column must have the numbers 1–9 in it, but they can only appear once
- Each 3x3 box must have the numbers 1–9 in it, but they can only appear once
The gist is this
– you use the constraints that already exist to derive the only possible
solution to what number should go in each cell. It’s maddening and addictive
all at the same time. And I firmly believe that every entrepreneur should spend
some serious time learning how to play.
Entrepreneurs, Business Models and Hot and Sour Soup
Every time I try a new Chinese restaurant, I always order the Hot and Sour soup. For me, this is the only test I need to understand how good the restaurant is going to be. The more urban (or would that be urbane) Tonya McKinney (Newmerix VP of Marketing) would offer a similar version of this for Sushi joints, “Always try the Uni first.” Arigato gozaimas, Tonya.
Regardless of your opinions on restaurant qualification, I
believe a similar test can be performed on an entrepreneur’s business plan. Just
skip the executive summary and look at their pro-forma business model. With a
relatively quick glance, I can tell if an entrepreneur understands how they
plan to build a business or not.
You see, business models are constraint based systems, just like Sudoku (you were wondering how I was going to pull all that together, weren’t you?). In a solid business model, everything has to match up top-down and bottom-up. Many first time entrepreneurs don’t understand this basic concept. I know I didn’t. It took Pat Kinnealy hours of poking and prodding at the model for my first company, Service Metrics, to finally understand what I now call “Business Model Integrity”.
The Only Rule You Need to Know About Revenue Projections
The problem is that many first time entrepreneurs focus only on the one metric they think VCs want to see – top line revenue. To some extent, VCs have to take some credit for creating this unhealthy dynamic. In the same way that Hot and Sour soup tells me if it’s worth my time ordering the mushu, top line revenue is a litmus test for many VCs to decide if they want to look further at a deal or not. You have to understand than most VCs bow at the altar of IRR. If you don’t bring them a business that might scale to 50MM within 5 years, you start to look like you might bring the class average down. The truth is that it’s a rare business that really grows like that, but we entrepreneurs and VCs all hold out hope nonetheless.
The only thing I can tell you definitively about top line revenue comes from Howard Diamond. Howard’s an extremely successful local Colorado entrepreneur. Recently I have had the pleasure of working with him on a business we’re both invested in, and thus have learned his many business aphorisms. My favorite, and most relevant to this conversation, is the following: “There is only one rule of revenue projections: whatever you project, you will be wrong.”
Now this doesn’t mean you will not hit the number, it simply
means you will be below it or above it. There just isn’t an SUV’s chance
on Earth Day that you will actually do what you put on paper. What matters to
VCs (and experienced entrepreneurs) is the all the numbers underneath the top
line revenue, and how they derive this number, as opposed to support it. These underlying
numbers tell the story of how your business needs to be funded to achieve the
top line goals you want and to ensure in a few years you can put that down
payment on the G5 you’ve had your eye on.
Rules of Thumb
Let’s take an example. Say for kicks that you are selling enterprise software. The rule of thumb here is that the sales cycle is about 6 months (give or take a couple of months depending on the complexity of requirements your buying syndicate will have). A direct sales person selling enterprise software can only work a certain number of deals at a time. Experience has told me that number is about 15 in a quarter. Each deal will be modeled at some average sales price. From this, you can quickly derive the top line revenue that your sales force will generate. If you look closely at this example, you will see there are some metrics that you control (you can plug into your model), and some metrics that are derived from the results of what you plug in (your model should produce for you). For example, you can change the number of sales people you have or you can change your expected average sales price. But keep in mind, just like Sudoku, before you put a number into your spreadsheet, it better keep the model’s integrity against some rule of thumb constraints.
Using this same example, let’s explore the constraints side. First, sales people tend to carry a quota. In a direct enterprise software sales force, quota’s generally end up being 1.2MM per year. In the first year of sales, you tend to scale this back a bit as the company, sales force, and market learns how your product will be sold (pricing, sales cycle, etc..). For large companies with big brand names, you sometimes see much larger quotas. But in general, that’s not realistic for a software startup that inevitably has to send the CEO into every big deal to make the buyer comfortable the company will still be in business 2 years from now. Second, the more sales people you have, the more deals they will need to be working. This will have direct impact on your marketing team and budget. A one person mostly mar-com team simply can’t direct mail their way to enough qualified opportunities for a 20 person sales force. It takes programs, telemarketing call-downs, lead qualification, webinars, and conferences, oh my! One of these days I will press Tonya to write a blarticle about this subject. She is by far the best metrics-based VP of Marketing I have ever had the chance to work with.
As you can see, there are constraints everywhere in the system. You need to keep building your model with educated guesses, while constantly cross checking these constraints. You’ll find that no matter what department you start with, you’ll quickly find yourself tangled in a spaghetti of key metrics related to other departments. This is okay – that’s how a business really works.
Johnny Cash, CFO
We’ve been talking a lot about the top line, but I would be remiss if I did not mention that annoying bottom part as well. This is the section of our exercise where you are graded on how many cells have parentheses around the numbers and how many do not. Johnny Cash summed this up for us extremely well (in both his name and his lyrics):
I fell in to a burning ring of fire
I went down,down,down
and the flames went higher.
And it burns,burns,burns
the ring of fire
the ring of fire.
At the end of the day, you will spend a lot of time working with all your constraints and metrics to try and derive the right top line revenue number. As your top line increases, you will be driven by visions of VCs doing back flips in their Aeron Chairs. And then, when you’re completely sure you’ve got the next Google, you’ll finally look at your cash burn line and realize you need $75MM to fund the thing in the first 18 months. Remember, while you will inevitably lead with top-line, you will close a VC on cash burn. A good rule of thumb here is that VCs go mildly apoplectic if your cash burn goes above 500K per month. When raising money, you usually raise about 18 months worth at a time. So doing some quick math that means you’ll need 9MM to fund 18 months at a 500K monthly burn. Even though the venture market is picking up, that’s a hefty chunk of money to raise and it will require a pretty august syndicate of players to pull off (more on this in “Death, Taxes, and Series A Cap Tables”).
Notice that I fudged a bit and did not say net cash
burn or gross cash burn (pre-revenue). This is one area where you’ve got
a little room to maneuver on the bottom line. But use your freedom wisely here and
always be aware of the differences in your model. The last thing you want to do
is show a monthly net cash burn of 500K, start giving everyone around the old
oak table high fives, and then have to field a question why your gross cash
burn is $2MM. Oh yeah, and why its that way in the first quarter of selling your
1.0 product. And the flames went higher…
The Devil’s In the Details, But so is the Story
6,670,903,752,021,072,936,960. No, this number is not the US national debt (well, not as of today that is). It is the number of possible Sudoku puzzles. That many? All from a simple 9x9 grid with only 3 simple constraints? Well yes, and it serves as a useful lesson for us. To some extent it may seem like my business model integrity exercise will always drive you to the same outcome. If you are constantly trying to solve for both the top line and the bottom line, and there are enough constraints in the system, isn’t there just one basic model everyone should used based on the nature of their business? Well, as Sudoku is our guide, the answer is clearly no.
The truth is there is an amazing subtlety to every business and thus a large number of viable models. The devil is truly in the details here. Your average sales price will drive an immense amount of the nature of the business model, as will your channel strategy. Products that sell for 30K simply can’t be sold with a direct sales force and products that sell for 2MM simply can’t be sold with a 6 month sales cycle. And from there you will drive marketing, services, support costs, infrastructure costs, etc.. Depending on what you are trying to accomplish, all of these moving parts will drive the business model in one direction or another. What’s most important is that it all adds up and you have ensured that all rule of thumb constraints are intact.
But just like the Devil, there is also a story in the details. And this is a fantastic opportunity that many entrepreneurs miss. In the end, you will have made choices about the metrics that you control, and those choices should be intimately tied to the story you want to tell about your business. Think of Benioff pitching Salesforce.com. No direct sales force, smaller engineering team (none of the overhead costs of deploying software into the field), completely annuity-based revenue stream. All for the trade-off of slightly higher infrastructure costs? Who do I make my check out to? I guarantee you the story was as obvious in the model as it was in the powerpoint!
I Can Name That Tune in 5 Notes
Okay – so I said that I can tell a well thought out business
plan from a bad one simply by looking at the business model. It’s actually very
easy to do and can usually be done in about five minutes by checking if five or
so of basic constraints I mentioned are met. If they are not, the entrepreneur
has got some work to do.
If you happen to be the entrepreneur in this story, all is not lost. The first thing you can do is make sure your executive summary or business plan doesn’t have a slide that says “Financials” and looks something like this:
2006 – 2M
2007 – 6M
2008 – 15M
2009 – 28M
2010 – 50M
2011 – G3 or G5? I haven’t decided yet.
The second thing you can do is sit down and make some sweet pro-forma modeling love to Excel. If you don’t know how to do this, the good news is a lot of people do. Find one of those people and start talking through your business with them. Start by separating the metrics you have control over from those that are intrinsically derived. Take a guess at some metrics, and check the constraints are still met. Pretty soon you’ll start to see the top line and bottom line of your business model shifting in one direction or another right in front of your eyes.
Last, but definitely not least, keep playing your Sudoku on a daily basis! It will be good mental pushups for the work you might have to do on your business model. And oh yeah, it might not hurt to have Johhny Cash playing in the background too.