Build. Measure. Learn. These are the principles that the Lean Startup lives by. In this blog post I am going to outline in detail how I believe a lean startup should integrate financial projections between each step of the process. I believe that financial projections can help you measure your potential for success from the very beginning and then as you continue to build, measure and learn you will hone in on developing a more accurate set of projections.
The reason I strongly believe in developing financial projections right from the get go is not because I think they will be accurate, it is because I think they might be able to uncover a fatal flaw in your business model sooner rather than later. Each time you learn and gather more data, you will be able to tweak your assumptions in your financial projections and determine whether or not there is still potential for profit.
Lean Startup Financial Projection Example
So now I want to go through an example of how an entrepreneur following the lean startup process might use financial projections to their benefit.
Imagine a Business Model or Two
So you come up with a solution to a problem and you want to build a business around this solution. In my humble opinion the first thing you should do is some simple back of a napkin type math and imagine what a business model might look like for this solution. I am not suggesting a 30 tab spreadsheet financial model for the next 5 years of the business. What I am suggesting is that you do 10 minutes of research and get a rough idea for the following data points:
How many customers might you be able to sell to?
How much might these customers be willing to pay?
How much will it cost you to produce this product or service?
The purpose of this exercise is to determine whether or not moving forward is worth your time. If you conclude that your total market for this product or service might be $50,000 annually, then maybe you should spend your valuable time elsewhere. Or maybe you realize that the technology just is not there yet, and it will cost you so much to produce the product that you would have to charge your customers an arm and a leg for the end product. Maybe this is what happened with the Apple Newton. The Apple Newton was a great idea, ahead of its time. How do we know this? Because of the success of the iPod, iPhone, and iPad, but the technology just wasn’t ready yet, and it cost too much for the limited functionality that it had.
Build an MVP
Once you have passed the first test, and it looks like there is a business model that could be profitable, now build your minimum viable product. Once you have a product or service for sale you can learn a number of details that will help you iterate on your financial projections.
For example, let’s say you built a software application that you are selling. Let’s also assume that it is NOT a recurring monthly or annual fee for the software. The user purchased a license once and it is theirs forever.
So you start out by selling it for $25 per license. It is already built, so there aren’t really any cost of goods sold expenses. In other words, you could sell 100 units or 1,000 units and your cost of goods sold would be the same. With that in mind, then it is really all about customer acquisition costs.
You might start out selling your product primarily through advertising with Google Adwords. You can test over a period of time and determine how much you pay in advertising for each unit you sell. Let’s say you are paying $32 worth of advertising for each $25 sale. It doesn’t take a rocket scientist to quickly determine that something must change. So you can either work to optimize your advertising to lower your cost to acquire a customer, or you can increase your pricing.
Adding New Features
As you add new features I think it is worth your time to create a quick financial projection for each feature. For example, you might want to add live chat support to your software. This is a slightly more complex projection, but a good example.
The question is how do you know whether or not it might be worth adding the new feature before you spend the development time.
Let’s say you are going to use an out of the box live chat system like Olark. You are also going to customize the integration a bit and you expect about 20 hours of development to be spent on implementation which will cost you about $1,000, along with $200 a month for the premium version of Olark. The other thing to take into consideration is that you will need to hire live chat support. Let’s say you pay $15 an hour and will have someone available 24 hours a day. That is an additional $10,800 a month.
So in total we are looking at a $1,000 up front investment and $11,000 monthly expense.
Now the question is how will the addition of a live chat feature impact your sales?
If you think it could drastically increase sales, it might be worth moving forward, BUT before you hire a few people to man your live chat desk 24 hours a day, you need to Build, Measure, and Learn to determine whether the finances make sense.
So you could implement the most basic version of Olark’s live chat feature and test to see if your sales conversion rate increases. Test it for a week. With the addition of live chat do you convert 20% more website visitors into customers? Now you can iterate on the financial projections again. Is the 20% sales increase enough to justify the additional expense?
You could run this same experiment with each 8 hour shift. Maybe it is profitable to have a live chat from 8 am to midnight, but not from midnight to 8 am.
With each cycle in the lean startup process I recommend a mini financial projection that can help you stay on the path toward a profitable business.
Let me know if you have any questions, I would love to chat. Shoot me an email at email@example.com