Is There a Market In The Gap? How To Assess The Financial Prospects Of Your New Business Idea
A new business idea is one of the most compelling and exciting things in the life of an entrepreneur.
Realising you have spotted an opportunity and thought of a new solution to a problem or unmet need, unleashing your creativity to expand and elaborate the idea into a full product concept, and thinking about how you will engage stakeholders and forge a path to the market are all part of the eureka experience. Often you just can’t wait to make a concept model of your product or sit down and start coding, writing a business plan or putting together a team.
However, to be really feasible, your business must not just make sense strategically, but also financially. (This requirement applies even if you want to start a non-profit social enterprise – you will still need to break even so that the venture can be viable.) A good number of entrepreneurs do invest considerable time in a start-up before realising that their financial model will not be sustainable, and sometimes a successful ‘pivot’ in the business model results. There are plenty of great stories about pivots in entrepreneurship lore, but let’s face it: there is also a risk that an entrepreneur will invest and lose everything, and history also includes many failures, from spectacular headline grabbers to the everyday mundane disappearance of redundant start-ups. That’s why your early ‘back of the envelope’ sketch for your business should also include some early financial assumptions.
Founders – even brainy technology entrepreneurs – often shy away from finance matters, but ‘the numbers’ are less arcane than many people assume.
The benefits of an early or preliminary financial assessment are:
- Understanding the kind of pricing and volume needed to cover costs and achieve profitability;
- Considering “risk” as a financial concept; in other words, will the returns be likely to compensate the risks and opportunity costs you are shouldering as an entrepreneur?
- Predicting early on whether outside investment might be needed to get to breakeven, and/or how long you can bootstrap.
This early financial assessment comes before the full market testing you will do at a later stage with a prototype, and also before the full-scale financial projections you would put in a business plan (many novice entrepreneurs make highly speculative or unrealistic financial projections in a business plan). At the same time, the exercise serves as a prompt for you to adopt an investor mindset, helps you qualify and quantify your financial objectives and priorities, and can offer an early warning that you may need to change your business model to improve the venture’s financial prospects.
There are three components to this assessment:
- Addressable market. The market segment you can capture needs to be big enough and offer enough potential customers and revenues to make the company scalable;
- Breakeven analysis. You need a rough idea of how much you must sell, as well as how long it will take, to recoup your costs;
- Return on investment to the entrepreneur. Here we use ROI as a conceptual term for a number of key financial issues entrepreneurs have to consider, for their own benefit, in the start-up phase, e.g. the cash and time (sweat equity) they are investing themselves, and how they want to be compensated for this investment.
A financially viable business model should satisfy all three components.
On TheNextWomen, we have already written a bit about qualifying and quantifying your addressable market in ’How to avoid a blind, shoot-from-the hip market estimation...’ and more can be read about how to segment and size your market in chapter 4 of The Smart Entrepreneur. It’s important to realise that you may only be able to capture one niche segment of a wider market in the early days, and to determine whether this can sustain the early business.
In a nutshell, this comes down to this question: sometimes there is a gap in the market, but is there also a market in the gap?
Your Breakeven Analysis is a rough test to work out how much you need to charge for your product or service (i.e. the lowest price) in order to at least cover your costs and get to breakeven, given the estimated size of your market. Once you have determined a breakeven price for your product or service, making a few basic assumptions about cost and sales volume, you can answer the question: is our ‘breakeven price’ competitive in the market?
If your breakeven price is already higher than that of the nearest existing competitor(s), you are facing a competitive and financial challenge with different potential outcomes (or a negative business case), unless you are certain that there is enough ‘customer pain’ to justify a premium price for your Unique Selling Point. (Some innovative products can command high price premiums if there is enough demand, but you’d do well to reality-check this assumption with some potential customers.) The idea is that your business model has to stand up at a minimum to this simplified profit and loss (P&L) model to assess financial viability.
This is an interactive process, e.g. a negative P&L may cause you to revise some of your assumptions about costs (such as overhead costs, your own compensation, and early production volumes) and thus produce a new or lower breakeven price. Depending on your funding, you may be able to tolerate a negative business result in an early phase, provided you are confident that the cost base will improve in the near term.
Determining your entrepreneurial Return on Investment is essentially a subjective exercise. The parameters to consider are essentially the time and money invested by you, and how you would like 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 (what kind of sales
cycle can I expect from my customers (B2B or consumer)? 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 further ahead?
Financial investors, typically think of the alternative uses of a sum of money (the opportunity cost) and compare the potential returns to the risk. A savings account in the bank offers a low return, but your money is at little risk (thanks to government insurance of savings deposits) and you have access to the money whenever you need it. In a start-up venture, you cannot get the money you invested back, even if you need it, until you ‘cash in’, when you either start distributing profits back to the owners or you sell the company and pocket the proceeds– if your business survives.
The risks and uncertainty of success are high, so start-up equity investors aim for an annual return of at least 30% and in some cases as much as 60% on the money invested. As a ‘sweat equity’ owner, you may decide that you want to pocket a similar return on the equivalent amount of money you would be paid to work as an employee over the same time period.
Do your addressable market and breakeven assessments offer the possibility of an acceptable profit and return on investment? Although you can never be 100% certain, you can try to look at comparable companies that have been sold, and compare the acquisition price to the level of revenue or profit the company was making in that year. That may give you an idea of the possible value of a proportionate level of revenue or profitability in your own business after a period of trading, when you have reached similar milestones.
These three assessments can lead to a number of possible e outcomes. As we said above, a viable business model should score well on all three assessment criteria.
However, if your business does not end up in the bottom row of the table above, all is not lost. You may make operational or financial changes to your business model to come up with different results. The suggestions below offer a few ways you might re-test your financial feasibility, with some revised assumptions:
Not giving up: changing the business model to improve possible outcomes
This way, casting a glance at the financial implications of your business strategy decisions from an early stage will help you consider a wider range of options to make your venture successful.
This article was written by Sabrina Kiefer and Irene Bejenke Walsh. Sabrina is a Venture Coach in the Entrepreneurship Hub at Imperial College Business School in London and co-author, with Prof. Bart Clarysse, of The Smart Entrepreneur.
Irene Bejenke Walsh, MD of MessageLab, is an experienced pitch and presentation trainer, specialising in investor presentations. A business journalist, entrepreneur and Angel investor herself, she founded her training consultancy, MessageLab, in 2000, and has since successfully coached more than 500 companies at all stages of the funding cycle for their investor pitches.
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