I have been working with my friends and colleagues at the FIU Pino Entrepreneurship Center to revise their workshop series. The workshops are offered to both students and local entrepreneurs to help them develop financeable business plans and are a key part of the preparation for the annual student business plan competition. The challenge in the workshops is to bridge the gap between the theory of the college classroom and the practical requirements of funding sources. What we are working on is a flowchart that demonstrates the process of developing a business plan and how the workshops support that process.
At the same time I have been reading the works of Clayton M. Christensen, the HBS professor who coined the term "disruptive technologies" and has written extensively on innovation and strategy. After coining the term, subsequent thinking led him to use a new term- "disruptive innovations". Christensen realized that it was business strategies and business models that created the disruption and not the technology alone.
The distinction between a business strategy and a business model is particularly important and appears to be frequently neglected in most of the business plans I see. A business strategy deals with the allocation of resources and I would define it as "the allocation of resources to increase shareholder value in an economically efficient way". The key resources are capital, people and time. The business model is the practical translation of the strategy and focuses principally on the revenue model, pricing and selling strategy required to achieve the growth objectives of the strategy. I also like to develop a headcount plan and a detailed understanding of capex in the business model given that they are frequently the largest requirements for capital.
With Christensen in mind and some input from Sequoia Capital's website, I have developed the flow chart below to explain the process of developing a business plan. This is a work in progress and I welcome comment. The descriptions that follow are intended to be illustrative and not comprehensive.
The process begins with the recognition of the customer need and then the formulation of a conceptual solution. The solution is then tested and refined by developing a business concept. The development of the business concept is an iterative process, meaning that any of the analysis in one of the four boxes can cause another part of the concept to be re-done. For me, business concept starts with identifying and defining a target customer with the identified need. The customer is then understood in the context of the market. (Michael Porter's Competitive Strategy is perhaps the definitive work on this type of analysis.) In this section of the analysis the all important question of market size should be determined, particularly given that it is one of the most important questions for venture capitalists. Next is the section on competitive analysis with particular attention to alternative technologies and distribution channels. Classic product definition is the next step where one defines the product features and benefits. The description and understanding of applicable technology, if any, and the related technology risks are the last part of preparing the business concept. After completing the business concept one should be clearly able to articulate the differential advantage, the unique set of features which will sustain the business.
I find that many people complete the development of a business concept and then skip right to the financial model. This approach frequently leads to very uninformative financial models. The financial models serves many purposes, not the least of which is to provide another opportunity to explain your business model and your logic for managing the business.
When I first learned to develop financial models (using a slide rule) I was taught to begin with the revenue assumptions. Revenue assumptions are now called "revenue drivers" and form the foundation for the first box in developing a business model--the revenue model. Growth in revenue comes from five alternatives or drivers:
- new accounts (B2B)
- new locations (retail, restaurants, etc.)
- new subscribers (telecom, cable, websites)
- new distribution outlets (think Haagen-Dazs)
- sales people (business services, B2B)
While the differences in the five alternatives may be subtle, each alternative has a different cost structure related to it. Fully explaining the assumptions behind any of these alternatives produces a revenue model. This "management logic" is, of course, showcased in the detail of the financial model also.
Another often neglected part of the overall analysis is the next step in business model development- pricing analysis. Rarely do I see business plans that show the sensitivity of gross margin or EBITDA to different outcomes in pricing or different pricing strategies. Bad pricing assumptions are one of the most frequent causes for companies to exhaust their capital prematurely.
Selling and distribution in the business model is the implementation plan for the selling strategy (how to get the customer) and would include the assumptions and expenses related to supporting your revenue drivers (in the revenue model). Customer acquisition cost or EBITDA contribution per sales person would be key assumptions developed at this stage. The sales person staffing for each new market would also be included here.
The next step is to develop a headcount plan. Headcount demonstrates the plan for adding staff by position by date. Metrics for adding customer service staff or a time line for adding programmers or R&D staff would be included. Growth in sales people developed in the last step would be transferred here to complete the headcount and salary and benefit assumptions by position complete the analysis.
The last step in the business model-CAPEX-highlights the recurring capital expenditures, whether it be store cost, routers and trunks for an ISP, or the cost of furniture, software and computers for customer service staff. Again, we develop metrics where applicable. At the conclusion of the business model analysis one should be able to clearly articulate the growth drivers in the business. (If the capital required for the business is not being invested in the growth drivers, one is well advised to re-work the business model or the financial plan.)
With the business model detailed and completed, developing the financial model becomes very easy because all of the key assumptions, except capital required, have been developed. The P&L, balance sheet and cash flow statement are prepared based on accrual accounting according to GAAP or IFRS. The level of detail in the P&L should generally match the level of detail in the business model, although overhead expenses will need to be further developed here. Developing the Sources & Uses is a usefully method for determining the capital requirement. Sources & Uses are discussed here in a previous post.
The last step in the process is to determine the feasibility of the project. We are seeking to determine the capital efficiency of the proposed new business, both on an IRR basis and in terms of return to investors. Should either of these measures fall below accepted levels, as shown in the diagram above one does not go back to the financial model but instead returns to the business concept or the business model. Changing key assumptions in the financial model alone, without considering their impact on the whole business model, is a poor method to refine a business plan.
On October 26th I will be giving an 8 hour workshop at FIU on building financial models. The workshop is open to the public. A small fee goes to the Entrepreneurship Center. Details can be found here. The workshop focuses on using the business model to develop the financial model and there are lots of real examples to illustrate the points.