By Nancy Hargreaves
As a CEO, when a board member or investor questions the feasibility of your company’s business model, you might be tempted to counter with the pat response “if it ain’t broke, don’t fix it”. But what if your business model IS broken? What should you do then?
I work frequently with early-stage life sciences and consumer companies marching towards commercialization. These high growth players are often driven by a founder’s passion and enthusiasm. I often find such energy both infectious and inspiring for the rest of us on the executive team. But sometimes, as a CFO, I have seen situations in which a crucial piece supporting the company’s business model, the financial plan, is deeply flawed. This can be because the core commercial assumptions supporting the company’s business model are incorrect or because of executional risks inherent with any early-stage company. The deficiencies in the financial strategy of a company may become obvious early on at the company’s inception or they may only surface through trial and error, over time.
The CFO’s Role: Building the Right Model for Decision Making
The ability of the executive team and the CEO to reevaluate the state of the business and pivot, if necessary, are a critical success factor for every company. The CFO’s job is to build and refine a strong financial strategy and plan which can incorporate various business, market and competitive assumptions and scenarios, allowing the management team to make informed decisions about which business model path is the optimal one to pursue. Each scenario needs to be tied to solid performance expectations and realistic operational and execution risks. Having a solid and flexible financial plan, as part of the organization’s overall strategic plan, with measurable goals, milestones and objectives allows the executive team, board of directors and CEO to make the best business decisions over both short- and longer-term horizons.
Business Model Scenarios: Financial Plan Inputs
There are four key areas which will make or break the success of any business model and scenario planning process:
- Scoping the right level of market opportunity
- Identifying appropriate revenue drivers
- Vetting results, benchmarking, and conducting “sanity checks”
- Ensuring accountability and measurability
Accurately Scoping Market Opportunities
Fundamentally, every company team must be able to define the true extent of “market opportunity” available to be captured. This may sound like an obvious place to start, but when a VC will not even look at opportunities where the market is not over $1.0 billion in revenue, this can create incentives to over project the total addressable market (TAM) size.
Especially with a new product or device, there should always be an initial, gating “go/no-go” decision based on the ROI of the market, percentage market share/penetration, international opportunities for expansion, the commercialization strategy (lease, buy, bundle, sell), the average selling price (ASP) the market will bear and the ability to improve COGS with volume over time.
Here’s a relevant example. A company I worked with had a niche medical device with an application in breast oncology. As there are only about 40,000 mastectomies carried out in the USA annually, with an ASP of $500, it was clear to us that the beachhead market opportunity was limited for this product. The financial model I developed for the executive team, however, helped quantify the potential upside market opportunity which could come from shifting the sales and strategic focus of the company to pursue other applications the device might have.
Identifying the Right Revenue Drivers
Every good business model includes a detailed set of assumptions around revenue drivers. As the CFO, you should define the fundamental drivers of revenue for your business, then make these variable assumptions in your business and financial model. I have often found that the best financial models allow the CEO and management team the flexibility to discuss and review real time changes to assumptions so that they can immediately and collectively view what the implications are for the business. Of course, you must be careful not to overcomplicate your plan with too much detail. The key is providing sufficient detail for the executive team so that together, you can streamline key decisions around strategic direction, operational changes, and investment levels.
Often comes as something of an epiphany when a company distills its essence down to the handful of factors which truly drive value over the long term. This can really be a gamechanger. When a team aligns around the fundamental business and revenue drivers for a business, this recommits them to the company’s core strategic focus and objectives.
Sometimes, something as simple as just timing of a strategic move can make a huge impact on a company’s plans. One company I worked with sold products which required significant up front capital investment prior to any revenue generation. Conventional wisdom had the team building out as many new facilities as it could, in as short a time frame as possible. We built our financial model, however, to allow for the phasing in of new customer acquisition over time. The model showed that it was more optimal for the company to invest in new facilities at a much slower pace, raise less capital and consequently require less dilution for company shareholders.
Benchmarking and Sanity Checks
A third piece of advice around business model scenario building is “always do a series of sanity checks” and preferably vet and benchmark your results before finalizing your decision.
Every business model analysis needs vetting using the best available benchmarking data and experts you have access to. You need to have a check and balance for your modeling process. And remember, unless your assumptions (particularly about market dynamics) stack up, they will soon be picked apart by potential investors. When looking at market dynamics and total addressable market and potential market share, you need to be reasonable. Check that over time, your plan is not projecting more than a reasonable percentage market share. If your customers are hospitals and doctors, check the TAM today and have data to back up any growth over time. What does the competition look like and how does that shape your business model’s assumptions on ASP and commercialization strategy? Too big a disconnect from historic actuals or hockey stick improvements going forward will inherently lead to either operational challenges in meeting those expectations or a lack of confidence amongst colleagues, the board and/or potential investors about the validity of the assumptions and drivers in your model.
Ensuring Accountability and Measurability
Finally, you need to make sure that your financial model can track through to being “operationalized” in practice via your accounting policies and systems. Will your accounting system give you the accurate and detailed answers you need to track actual performance to plan when you implement your new model?
Many pre-revenue, early-stage life sciences companies will use a basic general ledger and Quickbooks as their system of record. While there’s absolutely nothing wrong with Quickbooks per se, as your company grows, you need to know that your accounting systems can support reporting at the product line level – including product revenues, COGS and margins. How else will you effectively evaluate the most profitable products? Similarly, will your financial systems allow sales revenues and costs to be allocated to individual sales reps and regions so that the executive Sales team can spot any performance issues? Will your system allow project costs to be allocated correctly to accurately report on any deviations from planned project ROI’s? Unfortunately, if you can’t adequately track actual performance to stated objectives, KPI’s and targets in a timely way, any strategic course corrections may occur too late.
For the Finance team, it takes a significant investment of time to develop a road-tested and reliable financial business model at any company. Each business is unique. But ultimately, your model just needs to pass the “reasonableness test” in accurately predicting the future incorporating the right assumptions and drivers of revenues (and costs). The good news is that once your business model is finalized, it can be leveraged as a living, breathing and essential tool for management, the CFO and CEO. Once they have confidence in it, it will pave the way to better company decision making and success.