Part II: Finance
This article is the second of a five-part series on how we assess concepts and build ideas into businesses at High Alpha. In the first article, we discussed an idea’s “market score.”
Just for some preliminary context before you read this:
- High Alpha starts enterprise cloud companies, thus this methodology largely centers around these types of business outcomes. However, some parts may be more broadly applicable.
- High Alpha scores each criteria category from 1–4. We do this to intentionally eliminate any neutral scores.
- The score is partially subjective and is based on a weighting of all of the sub criteria of a section. Thus, scores can change over time based on if they are more developed or our views on a topic change.
Now that you’ve looked deeply into the market of your idea, you want to get into the good stuff: how you make money. While seemingly obvious, it’s actually really easy to get wrong or overlook. A lack of preparation to monetize and create value out of a business idea can lead to a higher cash burn rate, a shortened runway, or even the business never being able to get off the ground.
It’s important to note that there are a ton of different philosophies about finance. Even at High Alpha, we sometimes have multiple different view points about the financial prospects of an idea. This isn’t meant to be a definitive and highly calculated methodology behind how we value and decide the financial worth of an idea. We are simply attempting to determine the viability of a business idea in terms of its economics. Thus, even within the categories you’ll notice that the criteria is often more qualitative.
Startup finance is critical for a ton of reasons—some of them aren’t as obvious as others. Understanding the financial underpinnings of an idea may help in resource planning, hiring, and fundraising, but it also is a vital part of the strategy of a company. The way you monetize your product can directly impact who your customers are (enterprise vs. SMB), your hiring planning (inside sales rep vs. an enterprise sales rep), and even your product timeline (do you move quickly to build an MVP to start selling or can you take longer to build a more robust product?). At High Alpha we often use our financial data (qualitative and quantitative) about our companies to determine our short-term and long-term strategies, and it all starts with how we plan our monetization strategy when we start to build an idea.
When we look at “financials”, we have a few criteria we look��for:
- Revenue Model
- Investment (Cash) Runway
A revenue model is any mechanism for earning money for your product or service. When considering your revenue model, it’s important to try to create something that’s scalable and sustainable. Software-as-a-Service (SaaS) revenue models are usually more scalable because of their high gross margins. A scalable pricing model involves picking variables that help you increase the revenue you get from each customer as that customer gets more value from your product.
When considering the viability of a business, it’s worth listing out a variety of options for your revenue model. For example, for a business that sells BI tools, you can do a company-level license, a per-user license, a one-time fee, a freemium model, or individual module pricing. Even within those categories you could peg the revenue model to many different units such as utilization and users or just have a general license.
When considering what model is most effective, it’s advisable to socialize your model with potential customers. Pricing is iterative (many startups have price changes over time), but it’s important to have an initial stake in the ground. This helps to determine the efficacy of the model as well as the potential contract values of a deal when first beginning a business.
When talking to our potential customers, we try to get a quick bookend of the price range for them. We ask a number of simple questions:
- What’s the price at which you’d swipe your credit card immediately & not even think about it?
- At what point would you be offended by the price?
- What’s the middle point at which you’d have to assess the ROI to the business?
This feedback from customers is essential to understand if our perceived value matches theirs. A key takeaway here is that if you’re talking to more than one potential customer, a good rule of thumb is that 10–15% should be somewhat resistant to paying for the price. This helps to solve one of the biggest problems entrepreneurs have — pricing their product lower than they really should. But that’s a topic for another time. All of this information can help determine a price range for your product.
A good rule of thumb is that 10–15% of prospects should be somewhat resistant to paying your price. This helps to solve one of the biggest problems entrepreneurs have — pricing your product lower than you really should.
It’s also really valuable to go to your customers and find their unit of value. If you’re selling email marketing software, the unit of value is most likely the number of emails sent or number of subscribers in a database. This helps to create a system of revenue that is scalable. As the business scales, their unit of value or utilization should hypothetically increase, so pegging your revenue model to this unit of value will help to create the most logical revenue model while continuing to scale with the value created to the customer. The unit of value may be one single unit or it could be multiple, which could also inform you about the possible complexity of your idea and revenue model.
After finding some revenue strategies and potential contract values, you can start to use that data in order to determine the strength of the model. By using some of the TAM data from before, it’s possible to give a decent idea of the total revenue for the business based on the number of customers you can acquire with the revenue model.
For an idea to be effective, the revenue model should be scalable. Scalability refers to the revenue model expanding with the customer’s business as well as its deployability in different conditions. You should also consider scalability in the sense of being able to better leverage fixed assets. Thus, a scalable business model may be something that doesn’t require massive investment in order to build revenue, but can be deployed easily.
Let’s take an Applicant Tracking System as an example. As the company grows, it will likely use the application more. Hypothetically, a utilization-based revenue model could capture value most effectively. However, scalability can also refer to the revenue model’s efficacy for different types of businesses. A small business may have completely different utilization metrics that may be more relevant for a revenue model than a larger business.
The strength of the revenue model is more than just the total amount of revenue, but the additional opportunities for monetization (implementation, services, etc.). Small modifications such as making your revenue recurring can drastically affect your financial prospects, not to mention a generally higher multiple.
Typically investment runway refers to the amount of time an investment will get you before you need additional funds to continue operations. Think of it as how long your cash can sustain your business. It can be easily calculated by dividing your current cash position by your average cash burn. At High Alpha, we use this criteria to determine how long an idea will take in order to “return the investment.” This is a very general category and relies on two major questions:
- How long will it take for business to start making money?
- How fast can the company scale to return the investments made?
However they both boil down to speed to market.
The first question is likely the easier of the two. You should consider how long it takes to build your product. If your product is extremely complex or requires a significant amount of “table stakes” (minimum product requirements to be competitive in an industry), it can significantly increase how long it takes for you to start monetizing your business. Simpler businesses can monetize more quickly which allows them to have a longer runway.
The second question is much more difficult and relies on a solid go-to-market strategy. At High Alpha, we run many of our ideas through a simulated go-to-market tool called “the Nautilus” which we use to determine the strategy and ability for the company to hit major revenue benchmarks (generally $100K, $1M, $10M, and $100M). For each milestone, we consider product/features, number of customers, ACV, and the general go-to-market/customer acquisition strategy. With this framework, we can get a sense of how long it will take a company to truly scale to the size where it can return the investment. Companies that require more sales due to a lower contract value often have a longer investment runway. However, there are other variables such as the length of the sales cycle and the unique go-to-market nature of certain businesses that dictate the length of investment runway.
Combining these two variables, you should have a decent sense of how fast you can move with a business to return your investment. The faster you can do so is usually preferred, but a long investment runway shouldn’t be a reason to shy away from an idea. Many products that require big builds and customer education can become giant businesses, so it’s worth contextualizing the investment runway in terms of a risk profile. Although a short investment runway is less risky, it sometimes (but not always) can be a less rewarding idea, while longer investment runway ideas may be much more rewarding.
Combining these criteria will give you a more robust understanding of your business’s financial ability to succeed. A lot of this information comes from looking at the pricing and financing strategies of many other businesses. One article that was particularly helpful for me was by Dharmesh Shah linked here. A couple other good articles on SaaS pricing can be found here and here. The financial planning of your business is one of the most important things you can do, and by investing time to deeply understand the monetization opportunities in a business, the likelihood of success is greatly increased.
Thanks for reading about how we research the financial ability of an idea at High Alpha. Stay tuned for the next criteria category: The Customer Score.