Create an Economic Model

Startup success isn’t about making pretty spreadsheets, but your venture will probably sink or swim depending on whether the numbers work, so we better start the process of creating an economic model for your venture long before operations actually begin. 

Note that I said economic model, not financial statements. Financial statements are backward-looking documents detailing what happened last year for reporting and tax purposes. Right now we are creating a forward-looking model of how your venture’s economics might look. We don’t care about GAAP accounting rules, depreciation tables, or accrual methods at this stage, so don’t worry your pretty little head about any of that right now. 

I also tend to avoid saying “financial projections” because for a startup at this stage, revenue in year three is really just a wild-ass guess, so calling it a “projection” is a bit laughable. In fact, none of the numbers you come up with here will be right (especially for year three!), but you need a sense of the underlying economics of your proposed venture. 

I had a student once who refused to do any spreadsheets for his startup idea. He claimed that early-stage investors don’t care about financials anymore, just as they don’t care about formal business plans these days. Good luck with that. Every investor I know wants to understand how a venture’s numbers might work out. Most importantly, they want to invest in an entrepreneur who has actually spent some time thinking through the economics of their business model.

Yes, you need to build this yourself. 

Some inexperienced entrepreneurs find a freelancer who can build spreadsheets for them, while others find a spreadsheet template somewhere. But my opinion is that a successful startup founder needs to really understand and internalize their venture’s basic economics. If you’re going to manage the organization successfully and make good decisions, you have to understand the underlying economics of the operation, deep in your bones. That’s just not going to happen unless you build the spreadsheets yourself. 

Nothing is a brighter red flag for investors than asking a founder about a particular number on the spreadsheet and getting a response of: “I’m not sure; this is just a template I downloaded somewhere” or, worse yet, “I don’t know; I found a freelancer on Fiverr to build that spreadsheet.” Don’t be that guy.

You don’t need a master’s degree in accounting. 

Some first-time founders get nervous about building an economic model because they think it requires the specialized wisdom of a finance expert. It does not. Don’t overcomplicate this process, and don’t put off this task because you think you don’t have good enough accounting knowledge. Like everything else on the Launch Path, just enter your best guesses first, then you can refine, test, expand, and iterate as you go along. 

Eventually, you can have a financial expert review it for you, but for now, just get it going yourself. You are good enough, you are smart enough, and doggone it, people like you! 

The purpose of a good economic model.

The reason you’re going to want to start creating this now, early in the venture-building process, is that there are a variety of important things that will emerge from the process:

• Understanding the levers. 
  For any venture, there are often two or three key levers that really make a difference in the economics of the operations. For a manufacturing business it might be the materials cost; for a consulting business it might be the ratio of billable to non-billable hours; for a restaurant it might be the table churn rate. Once you build a solid economic model, you’ll be able to easily conduct sensitivity analysis that will help you understand where the meaningful levers are for your particular venture. I worked with a startup once that was desperately trying to get their materials costs down by a couple percentage points in order to improve their profit margin. I looked at their numbers and saw that they were paying almost 4% of every sale for credit card processing, and suggested they shop around and see if they could find a better deal. They found a payment processor charging 1.5%, and that one switch added more to their bottom line than all of their efforts to reduce materials cost. Once you have a good financial model built, it’s very easy to do “what if” scenarios that help you see which levers really matter.
  
• Informing the capital strategy.
  Once you’ve built an economic model, you’ll have a clearer picture of your capital needs at each stage. You’ll also have a better idea of the type of capital that makes sense. For example, if you have a solid cash flow after year one, then debt financing may make much more sense than equity financing. We’ll talk a lot more about capital strategies in the next chapter, and how a good economic model will help you choose the best way to finance your startup.
  
• Uncovering insights.In your head, you probably have already made some assumptions about your venture’s economics and your capital needs. But the process of actually building the economic model may yield insights that differ from your initial assumptions. Again, a fundamental part of the Launch Path process is to always be looking for ways to test and validate your assumptions. 
  
• Understanding scaling dynamics.
  Scaling one sort of company is different from scaling another sort of company. Building the economic model for your particular venture will help you understand the particular scaling dynamics you will encounter. For a consulting firm, for example, headcount typically goes up with a linear relationship to revenue. Consulting firms bill by the hour, and so to double the revenue you need to double the number of consultants. With a software company, doubling the revenue may not require double the people, but it may require additional investment in server infrastructure. Again, the point is that you need to immerse yourself in what the economic dynamics of your particular venture will look and feel like. 
  
• Communicating with investors.
  As Guy Kawasaki has written, “The point of an economic model is to tell a story with numbers—a story about opportunity, resource requirements, market forces, growth, milestone achievements, and profits.” Having a well-thought-through economic model is an important part of being able to talk to investors about your startup. You’re telling a story, with numbers. 

OK, Fire-Up Your Spreadsheet!

Are you ready to do this thing? I’ll walk you through the process of creating the initial economic model for your brand-new startup concept – no accounting skills required! Click here to view an example economic model for our awesome fictional venture, Fitaco. You can make a copy of that spreadsheet, if that helps you to follow along with with my narrative here as you build one for your venture. 

What you’re building is a model of the economic rationale by which you expect to create, deliver, and capture value for your customers (which you’ll remember as my definition of a business model).

I like to do the other parts of the Launch Path Canvas first, so that I’ve got a reasonably good picture in my head of the elements of this particular venture, and then I use that to inform the creation of a spreadsheet representing the economic model. For the first year of your new startup, you’ll want a spreadsheet with everything listed by month. For years two and beyond, you may want to use quarters instead of months, but for a new startup it will likely be more useful to look at months. 

When you look at my example on thelaunchpath.com, you’ll notice that I like to put everything on separate spreadsheet tabs. I do this for ease in making adjustments as I continue to refine a startup’s economic model.
Here are the various tabs on my spreadsheet and a description of each:

• Assumptions
  Put all your assumptions on one tab so you can change them in one place and see how they flow through the entire model. An example might be “credit card fees.” If you’re assuming you’ll pay a credit card fee of three percent, then later you get a good deal and can get that down to 1.85 percent, you can just change it in one place on the Assumptions tab, and it will automatically flow everywhere else. 
• Setup Costs
  There are always some one-time costs to get your venture going. For example, the cost of forming the corporation is a one-time cost, not a recurring cost.  I like to put these one-time startup costs on a separate tab, as they are not part of ongoing operating expenses. 
• Sales, General, and Administrative (SG&A)
  This is what most people would just call “overhead”—rent, insurance, utilities, stuff like that. Sometimes these are called “fixed costs” because they don’t vary month to month depending on how many widgets we make and sell. Put all of your estimated overhead costs on this tab. Again, don’t worry about all the numbers being right, just add in rows for all the different operating expenses you think your venture will likely incur. 
• People
  People are the largest expense for most ventures, so put them on a separate tab. Group them by function, because eventually salespeople will go into a different expense category than engineers, for example. Maybe you’ll have some freelancers and contractors at first, and then you will hire full-time staff. Keep contractors and payroll employees separate, because employees will cost you more than their salaries, once you add payroll taxes and benefits. This added amount is called a load factor. For example, if we pay someone a salary of $100,000 they’ll cost us more like $130,000 when we include payroll taxes and benefits, so the load factor is 30%. I like to put that load factor on the Assumptions tab, and then you can easily refine it later. Your venture will probably end up with a payroll load factor somewhere in the range of 20-40%, depending on the labor law where you’re operating, and the extent of your benefits package. Just put 30% on the Assumptions tab for now. 
• Revenue
  You won’t yet really have any idea of your new venture’s revenue, but you need to have it represented correctly in your model. Do you think you’ll start earning revenue in the first month, or is yours the sort of venture where there will be no revenue until month seven? If you have a subscription business, then your revenue is the number of subscribers each month times your monthly subscription fee. Of course, with a subscription business, there’s always churn—the number of people every month who cancel their subscriptions. All of that should be modeled in some way on the Revenue tab. Again, having the numbers right isn’t as important right now as creating a logical model that produces clear and easy-to-understand results. You can refine the actual numbers as you go along.
• Cost of Goods Sold (COGS)
  Your cost of goods sold (COGS) is the traditional way of representing what the products you sold cost you to make. If you sold one hundred loaves of bread for one thousand dollars total, the COGS include the flour, water, yeast, salt, and labor costs in making those one hundred loaves. The COGS is not the overhead costs of running the organization; it’s just the costs related to making the products you sold. You, as CEO, are overhead, whereas the baker mixing bread dough all day is part of the COGS required to make each loaf of bread you sell. Sometimes you will hear this called “variable cost” or “direct labor” (meaning that, if you double the number of products you are shipping, you’ll need to hire another shipping guy, so the cost is variable depending on how many products you ship each month). This gets a little squishy with some business models. For example, with a software-as-a-service (SaaS) business, there is no manufacturing cost, but you probably want to record the cost of running the servers (and support personnel) upon which your SaaS platform is delivered to customers.
• Summary Tab
  All of your data should roll up onto a single Summary tab that gives an overview of the story. Startups typically run at a loss at first and then eventually turn profitable, so I like to have a cumulative “running cash balance” across the bottom, as that will help inform how much capital you’ll need to start and scale the business. 

Once you fill out your spreadsheet, you can refine the numbers, test some assumptions, and after iterating on it a few times you’ll begin to have a functioning economic model for your venture. Remember, like everything else in the Launch Path process, you’re putting down your bests guesses first, then finding ways you can validate your guesses and refine toward a final form.

Capital Expenses vs. Operating Expenses

You’ll likely hear accountants talk about Capital Expenses and Operating Expenses. From an accounting perspective, CapEx and OpEx are different animals, represented on financial statements in a completely different way. Right now, for your early-stage venture, all you need to care about is cash. If you buy a one-hundred-thousand-dollar piece of equipment, it’s cash out the door, just the same as paying one hundred thousand dollars for a marketing campaign. So, don’t worry about CapEx and depreciation tables; let your CPA worry about that later.

Eventually, you will have financial statements. 

For now we are creating a forward-looking economic model for our venture, which is different from the formal (backward-looking) financial statements you will eventually have, prepared by your bookeeper and CPA. Eventually every venture keeps a set of financial statements that typically have three components:

• Balance Sheet
  This is simply a list of the company’s assets and liabilities at a particular snapshot in time. If we have one thousand dollars in the bank (assets), and we owe three hundred dollars in debt (liabilities), then the net of that (our equity) is seven hundred dollars. Equity plus liabilities equals assets (they balance). That’s all there is to that. The first questions an investor asks about a balance sheet will be: How much cash do you have, and when does it run out? How healthy are your accounts receivable? Are you behind on your payables?

• Income Statement (Profit & Loss Statement)
  This shows a particular time period (maybe a year, divided up by month), along with your revenue and expenses during that same time period. Revenue minus expenses equals income (profit). If you ended the year with five hundred dollars in net income (profit), then you’d expect that the assets on your balance sheet also increased by five hundred dollars.  
• Cash Flow Statements 
  If one month’s expenses totaled two hundred dollars, and you billed your customers one thousand dollars, then you made eight hundred dollars, and you’re happy, right? Except that maybe your customers aren’t going to pay their bills until next month. For reasons like these, the income statement may not exactly represent how the cash flows, and that’s what cash flow statements are for. 

But as I said, don’t worry about these financial statements right now. You’re simply going to build an economic model, a numbers-based story about how your venture will create, deliver, and capture value for customers. 

Every startup venture needs to eventually have a profitable economic engine. Once you get the flywheel going, that engine will (hopefully) create more dollars than it consumes each year.