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

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

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 ?
entrepreneur
business
• Is the addressable
market big enough to
make commercial sense?
(See Entrepreneurial
Market Research in IE&D
Toolbox)
market
• 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
Productvolume
Competition
price 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
Return on
investment

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
Return on
investment

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
Return on
investment

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.
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Business model financial viability 2013

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