In the world of the Lean Startup, what is the value of forecasting and how do financial models fit in?
[tboot_highlight color=”blue”]Numbers are crucial for understanding a company, but they’re meaningless without ‘market fact’. The financial model is not dead. They continue to play a valuable role, so long as companies use them properly as they reach different stages of growth.[/tboot_highlight]
The Business Plan is Dead.
What about the Financial Model?
I’ve built a lot of models in my time. When you’re working with people to shape the future of a company, you need to have a solid understanding of the numbers. I’ve found, time and again, that when I reduce an idea to numbers I can tell how much I truly understand it. When I’ve done that well, I’ve found a robust set of numbers can show me which idea is the best of the bunch.
However in the past 5 years, the world of startups, innovation and entrepreneurship has changed. The work of Steve Blank and Eric Ries have popularized the idea of the Lean Startup – a new approach to creating new companies or products which relies hypothesis testing and iterative development. The 5-year business plan is now dead, and if you show up to an investor meeting with a 40+ page business plan, you will have shot your credibility as well. Today, relying on a business plan is a signal you aren’t prepared to adjust to the market and learn what you should really be building. As Steve Blank says, “no business plan survives first contact with the customer”.
But what about the financial model? Is that dead too? Surely there is still some value in understanding the financial future of a company. Is it not important for an entrepreneur to plan their company’s future financial performance (and needs)? Financial models have traditionally been the first appendix of every business plan, but if the business plan is dead, does that mean the financial model is too?
I Decided to ask Alex Osterwalder
Alex Osterwalder is the author of the groundbreaking book, “Business Model Generation”. In it, he introduces a framework for designing business models. He has since teamed up with Steve Blank and Eric Ries, and the combination of their theories forms what we know as the Lean Startup movement today. The bedrock of the entire movement is Alex’s Business Model Canvas, which the Lean Startup movement has adapted into the Lean Startup Canvas.
I am lucky enough to share a mutual friend with Alex Osterwalder who made an introduction so we could arrange a call. I was curious to get Alex’s opinion on where financial planning fits into the innovation process.
Firstly, I want to emphasize that Alex is a really great guy. He took a call from someone he didn’t know, when his time is in hot demand all over the world (and highly priced). This is partly the reason for me writing this post, to share the outcome with the broader community.
Top 9 Highlights from the Conversation
1) Numbers are important. There are 3 boxes on the Lean Canvas that are quantitative (Key Metrics, Cost Structure, Revenue Streams). A thorough understanding of the numbers creates a deeper understanding of the business.
2) Numbers are meaningless if they are not based on “market fact”. This was Alex’s main point. He is all in favor of quantitative evidence for ideas, but it must be evidence based on fact gathered during the customer development and hypothesis testing process, not just assumptions from the founding team.
3) Diving into the numbers too early, or in too much detail, is a waste of time if you have no market fact.
4) The numbers will always look different after you start testing. They will change as you learn more and gather market fact.
5) If investors buy into projections that are not based on market fact, the founding team may be held accountable to achieve them. This can create problems down the road because if the projections are fictitious, the founding team may be held accountable for something that’s impossible to achieve.
6) Smarter investors will ask for something else. They will say “you’re showing me this number, but tell me why this is not bullshit”. It’s on the founding team to demonstrate fact to back them up. Cutting edge VC’s will rarely invest without market fact.
7) When a company moves past the startup phase, their projections take on a new significance. Numbers become important for execution and are most valuable at an operational level.
8) Even big companies fall into the trap of doing detailed projections before gathering fact. It’s not a problem restricted to startups. The ‘fact-before-projection’ rule exists for everyone if their numbers are going to be meaningful.
9) If you don’t have market fact, the most value you will get is structure and clarity about how the business could work, and possibly use that perspective to set goals. Its important to treat the projections for what they are: goals, not reality.
What Does this Mean for Entrepreneurs?
This conversation with Alex was clear about one point: numbers are important, but facts are more important than spreadsheets.
Ultimately, the need and role for a financial model or set of forecasts depends on two major factors: (1) How much ‘fact’ do you have (as opposed to pure assumption), and (2) What stage of development is the company?
If you have little or no fact, any numbers you put into a spreadsheet are going to be garbage. As the saying goes “garbage in, garbage out”. This is an inescapable truth. If the model is a work of fiction the most value it can have is to clarify the thinking of the team on what they need to test. Numbers based on assumption are not a reliable way to make decision or plans. At best, such projections are goals.
Secondly, the role of a financial model changes as a company grows, which I discuss in the next section.
The Role of a Financial Model in 3 Company Types
There are three major stages of company development that impact how a company should use a financial model:
A) Startup, Pre-Revenue
Pre-revenue startups have not yet earned money from their customers, and they are arguably still looking for product-market fit. According to the Lean Startup movement, the major planning tool for companies in this stage of the game is the Lean Startup Canvas which can guide which business model hypotheses to test and experiments to run. If you want to be very scientific about the process, a product called Javelin developed by
In circumstances like this, the profit equation is “-Profit = Cost”, and the financial metric that matters most is the “Burn Rate”, or more importantly, “Months of Life” (where MoL = Cash on Hand / Burn Rate). It’s crucial to monitor this metric closely because the company will die if it burns through its initial investment (either from founders or external investors) and runs out of cash. Some have said that the life of a company should also be measured in the number of pivots it can afford, so when you take this a bit further, another metric become important, i.e. “Available Pivots = Cash on Hand / Cost per Pivot”. It can take 3 wholesale pivots before a company finally finds product-market fit. Some companies take less, some take many more – but the reality is if you run out of cash and can’t get more, you’re dead.
The role of a financial model for Pre-Revenue Startups is to make sure it doesn’t run out of cash. It should be used as a cost management tool to guide decisions that give the company as much life as possible. Most of the time, cost based information is observable fact, so unless the company is overoptimistic about how cheaply it can acquire things, or how quickly milestones can be reached, a financial model will give reliable results. In any case, it should be kept up to date regularly so the team can react to any surprises it experiences.
B) Startup, Some Revenue
By this stage, the company is bringing in some revenue from customers but has not yet reached break even. This becomes the first important metric, specifically “Break Even = (# Sales x $ per Sale) / Operating Cost”.
If a company achieves it’s break-even point, the clock of death stops ticking. A company can exist at its break-even point infinitely because it is not consuming cash on hand, however it cannot grow aggressively either. In most cases, aggressive growth requires an outlay of cash upfront. Some exceptions exist, such as when a sale can be made which brings in cash before any expenses need to be incurred. One example could be an enterprise software sale where the cost of implementation/customization is fully borne by the customer in a consulting contract. By and large, the break even point represents a sustainable status-quo.
In these cases, the best use of a financial model is to set sales goals. To grow, the company will want to get past its break-even point with profitable sales as quickly as possible. There is no real way to predict sales volume with 100% certainty, so revenue ‘projections’ will not be based on market fact, however the team can definitely use its market knowledge to set reasonable goals and go after them. If the team is clever and keeps tracks its performance, it will be able to learn how effective they are at estimate sales and calibrate themselves to prevent being too optimistic or pessimistic.
C) Post-Startup, Profitable and Growing
Once a company has achieved product-market fit, is profitable and growing – a financial model will come into it’s own. By this stage, the company will have lots of market fact upon which to base some projections. They will have past trends in sales performance, an understanding of their customers needs, increasing volumes of attention and feedback in the market, and an innate understanding of what they must to do satisfy their customers and grow.
Arguably, this is the time for doing “detailed numbers”. The company has market facts which it can use to create sound forecasts (at least for 12 months) and can manage the company’s operations through a wide range of metrics. Growth can be paid for with the cash the company is generating and how well the company is executing can be measured.
A financial model in these circumstances becomes a very powerful tool. Good financial models will capture the underlying ‘physics’ of the company’s business model and savvy companies will distill their financial formula down into a single dashboard perhaps showing 5-10 key metrics that have a >90% predictor of company performance. The permutations of what can be shown on a dashboard are almost endless, and worthy of an entire post (or 10) so I won’t go into more detail here. The important thing is that financial models can inform which metrics matter.
Founders who get caught up in the fun of rapid growth and take their eyes of the numbers can find themselves making costly mistakes (spending too much, hiring too fast, wasting marketing spend, adding overhead). By contrast, the best companies will have screens in their office showing the company’s dashboard so every employee can the company’s vital signs in real time. In fact, Jack Dorsey is famous for his dashboards and they were instrumental in Twitter’s early growth.
The business plan is dead, but the financial model isn’t. Numbers are important in every company, and the challenge for entrepreneurs is to use their numbers in the right way at the right time. Savvy companies will use the Business Model Canvas to find product-market fit and a financial model to manage their cost; once break even has been achieved they’ll set sales goals to support growth; and then develop a full range of projections to make strategic and operational decisions once they’re profitable and growing. This is the new world for managing the inventive and practical elements of building a company.
Feel free to share your thoughts in the comments below.