Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote an article with tips for analyzing startup business models. Her full article (with her permission) appears further below.
Can the company you are considering investing in scale and get to a good exit? How is it going to make money, really? These are some of the most important questions every angel investor needs good answers for from the entrepreneur. Successfully evaluating a startup business model can make the difference between success and failure of your investment.
Business models can be stated simply – like “razor blades” (offering a high margin shaver at a good price in order to increase sales of razor blades) and “freemiums” (offering basic services for free and charging for premium services) – but they involve the detailed overall strategy of the company. A business model is how the company defines the market and its products, along with how it gets and keeps customers, how they get to the market, and how its resources are set up, all while eventually making a profit. Startup business models are even more complicated because most startups are essentially experimenting with their strategies and will evolve their model as they test it out.
Many entrepreneurs and investors use the Business Model Canvas by Alexander Osterwalder to develop and evaluate business models. Brigitte Baumann, founder and CEO of international angel group Go Beyond Investing and 2014 European Business Angel of the Year, takes more of an economic approach. I’ve been working with Baumann to develop a set of free resources for new angels to get started successfully and connected with her recently on how angels evaluate business models.
When Baumann reviews a business model her first step is to sort the business plan information into four economic-focused building blocks:
- Unit economics: the hard data that include the selling price of the product or service and the costs involved.
- Customer economics: customer acquisition, retention and support).
- Market economics: what it will take for the entrepreneur to actually create the market buzz or demand needed to acquire customers who will use the units.
- Business economics: the development and overhead; this includes anything from additional offices that might open to support for handling finances, etc.
Thinking about a business model through these four lenses helps to get to an understanding about how much money an entrepreneur needs in order to become self-sustaining. It also makes the financial goals for each round of funding more obvious.
Knowing how entrepreneurs think about the business model is very important. To quote Baumann, “The entrepreneurial team should all ‘live’ the model. They touch it every single day in every action that they do.”
Naturally getting to those important answers requires analyzing the business model from two crucial perspectives: scalability and the break-even point.
Scalability – is a key indicator in whether or not a company will go public or be acquired and investors will get returns on their investments. It is about a company’s ability to multiply revenue with minimal incremental cost, creating a profitable and valuable business. Baumann suggests that when angels meet an entrepreneur, we need to understand whether he or she is planning for 3x, 10x or 100x growth from where they are currently.
Knowing which level helps investors understand the amount of money the entrepreneur needs to raise and in how many rounds. A company that is planning for a 100x growth is likely further along in their development and has the chance of a great exit for all involved.
The Break Even Point – Beyond scalability it is important to understand the company’s break-even point, when it becomes self-sustainable and doesn’t require more outside capital. Baumann has a chart to determine break-even, incorporating fixed and variable costs, as well as the incremental costs that come with increased scalability in a new video.
To understand scalability and break-even points in due diligence, angels need to understand the economics of the company’s revenue growth plan and when they are a “real business.” Questions to investigate how revenues will grow and all of the involved costs. Make sure entrepreneurs are realistic about how much money they will need to get to break-even by asking them where the current round of funding will take them, how many rounds of funding they think they will need, what resources they need to get to each level of scalability and what milestones they accomplish in each round.
Many scalable business models involve big margins between true product costs and selling prices and/or pricing mark-ups. But angels need to make sure the entrepreneurs have thought through all of the relevant costs, including the costs of customer acquisition, retention and support over the lifetime of the customer relationship.
Other critical things to check into during due diligence are the market economics, particularly whether they are using the true accessible market and whether their potential share of the market is possible. These days, it is easier and easier to get data on the company’s existing competitors to get data to compare to.
The bottom line is it is key that entrepreneurs and investors understand the business model before reviewing the financials. Entrepreneurs need to know the drivers that capture market share, outmaneuver the competition and make the business succeed. And investors need to know how to get that information out of the business model or help entrepreneurs build a business model that provides those answers. Without this knowledge it’s difficult to properly evaluate a startup and to make a wise investment decision.