The road to entrepreneurship – part 3: Creating a fail-proof business model

As in the earlier parts of this series, our focus is on the bootstrap entrepreneur who may not have a fixed and firm business plan, who funds his business through modest and limited savings of his own, and has no major advantages, such as patented killer products, or a captive customer who will pay a profitable price. If you do happen to have some or all of those advantages, however, this could still be useful!

In the first several months of a startup’s life (often, the first few years), the main objective should not be to maximize revenues or profits, or to accelerate growth; it should instead be, to guarantee survival. For this, you need a fail-proof business model (FPBM), which will ensure that your startup would survive indefinitely if there are no major changes in conditions. The FPBM may not make you rich quickly, but it will give you freedom from worrying about survival. It will therefore allow you to build more sophisticated and profitable product or service offerings, or create advanced strategies for fast growth later on. However, not having an FPBM could render your startup vulnerable, and even prone to collapse, even if you have very compelling products and capabilities. I am sure that the vast majority of startups which fail, (especially many “surprising failures” founded by very capable and intelligent entrepreneurs), do so because of the absence of an FPBM.

So what is an FPBM? As we all know, nothing in the universe is 100% fail-proof – no matter how well you plan, a greater-than-expected disaster might strike. The point is, while you can never achieve 100% safety, you can keep traveling as far as you want towards the target of 100% safety… and the further you travel, the more risk-free you make your startup, which will guarantee its survival, and strengthen its base for future growth.

To explain FPBM, let us start with the simplistic explanation of profitability which everyone understands: you invest a certain amount of resource to deliver a product or service (let us call it “offering”) to a customer – this is your cost. The customer consumes your offering and pays you a higher amount – this is your revenue. The revenue you realize, should recover for you your total cost, plus it should leave you with some surplus, which is your profit. Now the entire concept of FPBM, which is the complete mantra to guarantee survival of the startup, is just the simple equation above, with three additional variables thrown in: hidden cost, risk and cash rotation!

So let us move on to the math which will help us create our FPBM – consider one single business transaction to begin with:

Equation 1: Profit = Revenue – Cost
Equation 2: Profit = Revenue – (Cost + Hidden Cost)

Equation 1 is the simplistic definition that everyone knows, while Equation 2 is a more precise calculation of profit. Notice that “revenue” is the same in equation 1 & 2… it is easy and unambiguous to measure, as it is the actual amount that the customer pays, so all you need to do is count what you get or read the amount on the cheque!

However, “hidden cost” could contain lots of fuzzy details, including examples such as:

• As a startup entrepreneur, are you paying yourself a fair salary?
• Are you at least collecting from your startup business enough money to cover your personal and family expenses, without postponing important purchases?
• If your revenue collection happens very late, what is the interest you pay on working capital?
• Did you have to borrow money to fork up the initial investment for your first business transaction, which you will have to pay back later, with interest?
• Did you make a commitment on this sale, for which you may have to spend time on this transaction later, for which the cost is not known, but the revenue is already limited to its initial value?
• Currently, you may be working from home, so your pricing does not cover the cost of an office. If your scale goes up and you move to an office, but overlook changing your pricing, or you are unable to due to market pressure, this is another hidden cost which can creep in.

Now quite often, real profit may turn out to be negative, if you measure hidden cost over-strictly… but an entrepreneur could disregard this, as he should also, by nature, maintain a healthy degree of optimistic and selective approximation, which we will suitably temper by applying our additional variables as shown below:

Equation 3: Profit = (Revenue – Revenue Reduction due to Risk) – (Cost + Hidden Cost + Cost Increase due to Risk)

Equation 3 is an even more realistic calculation of profit. So now, we have a potential reduction in revenue, as well as a potential increase in cost, due to risk. Risk is difficult to measure and may or may not happen, while hidden cost is difficult to measure, but will definitely get incurred. An example of risk is that the customer refuses to pay part of, or the whole of, what you bill him … so revenue may get reduced, or wiped out altogether.

If by now, you feel that the startup’s prospects are getting gloomier by the minute, let me assure you there is hope in the final variable, which is both an opportunity and a challenge – cash rotation.

Let us rewrite Equation 3 with the following symbols:
P = Profit
R = Revenue paid by Customer
rR = revenue reduction due to risk
C = Cost of delivering the offering to the Customer
HC = Hidden Cost
rC = cost increase due to risk

Equation 3: P = (R – rR) – (C + HC + rC)
Over a large number of transactions, the total would be the sums of all the transactions, or the sigma (∑):

Equation 4: ∑P = (∑R –∑ rR) – (∑C + ∑HC + ∑rC)

This would describe the total profit on transactions, for say July, Aug & Sep, to be the difference between total real revenue (revenue – loss due to risk) and total cost (cost + hidden cost + increase due to risk).

However, in reality, transactions happen continuously across time periods – July may have carried over transactions from June and even earlier, the closure of transactions in Sep may happen in Oct or later, and so on. Also, how you recognize revenue and profit for a period (whether on accrual, or project operation, or on cash basis) is a subject by itself, and one which we will not get into here.

What matters is this: the cash that comes into your startup company as revenues, after reductions due to risk, should be enough to cover the cash that is going out of the company not only to fund the production of offerings being delivered to customers, but also to cover fixed periodic expenses such as office rent, salaries for staff, electricity, internet & phone bills, installments on loans etc. If we denote these fixed expenses, or fixed costs, as FC, then we have an even more precise measurement of profit

Equation 5: ∑P = (∑R –∑ rR) – (∑C + ∑HC + ∑rC + FC)

The technical treatment of measurement of actual profit of a firm is obviously a huge ocean of a subject in itself, bringing in other factors such as depreciation, amortization, tax and so on, but we are restricting ourselves here to creating an FPBM for a simple, unfunded small business, so we can ignore these complexities for the moment.

Now, the actual FPBM that you create for your business, should satisfy the following conditions, for every rolling quarter (three months taken together, eg July-Aug-Sep, then Aug-Sep-Oct, then Sep-Oct-Nov, then Oct-Nov-Dec etc)

1. ∑P should be positive in Equation 5: ∑P = (∑R –∑ rR) – (∑C + ∑HC + ∑rC + FC)
2. Cash collected from revenues should cover cash being spent on delivery of offerings as well as fixed costs… this includes a few more points:

• The cash collected could be for offerings delivered in July, but the costs being paid for, could be for offerings to be delivered in Sep... that does not matter!
• One way to ensure that cash available from collections covers all payouts to be made is to collect a lot of cash, really fast from Customers… but this is not always possible
• The other way, is to negotiate for extended credit periods from suppliers, so that your cash payout also slows down
• Either way, inflow should be as fast as possible, while outflow should be as slow as possible (without hurting basic business ethical considerations, of course, such as paying salaries to employees on time!) This is in fact, the essence of cash-flow management for a small business

Creating and stabilizing an FPBM which does all the above, may take weeks, months, or even a couple of years, but it is well worth the effort:

1. If you are a serious startup entrepreneur, looking at creating the next business behemoth, but currently bootstrapping, then stop everything else and first build a strong FPBM
2. To design and build that FPBM, focus on just two target variables: profitability and cash-flow management
3. To get profitability and cash-flow management right, analyze your customer revenues (and therefore pricing), your risk, your cost of delivery, hidden cost and your cash rotation

Once you get your FPBM right, the world is your playground :) - it is worthwhile to sacrifice other tempting preoccupations in the short term, like diversifying into new products, expanding into other geographies etc, until you have a good grip on your FPBM. After that, even as you expand and diversify, never lose sight of your FPBM!

In the next part, we will talk about how a bootstrap startup can acquire customers, retain them and manage relationships to grow predictably.