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Sunday, March 2, 2014

How to think about Revenues and Costs in a startup

Over the years, i have been both running internet business and investing in internet businesses. In both cases, management will always have a profit and loss projection for the year. I have seen enough internet P&Ls and tracked enough such P&Ls that i have come to some conclusions for our region. Here are 2 major  :

1) Revenue projections are almost always optimistic.

I have must seen and helped or tracked more than 100 internet businesses by now based in SG and MY. Of these, only a handful have revenue projections that are largely achieved. And these are usually achieved due to market conditions being extremely favourable. A good example is Groupon SG and MY which rode the adoption of ecommerce in a big way. Or job portals and property portals which rode the economic growth and property market growth. Of course execution matters equally too. Usually companies that achieve their projections are those who executed very well on a day to day sales and operations basis and which are also aided by market trends which added wind to their sails.

What about the rest? Most of the other startups fall short of their projections. A common mistake is to assume a certain conversion rate for platform plays without taking into account that as one scales up, the conversion rates could change for the worse. For sales team plays, a common mistake is to assume scalability of sales staff without taking into account the fact that it takes time to train up a sales staff and that attrition for corporate sales startups is pretty high. Also sales management is not something easy to get right from the start.

Another common mistake is to assume revenue from new markets based on old market assumptions. I have seen many business plans where SG makes X revenue and the assumption is to grow MY and ID at the same pace as SG. This is quite dangerous. Many reasons. One is that core team that made it work is still in SG and not the new country. Another reason is that SG core assumptions are significantly different from new market. Another close parallel of this is assuming in your projection that you can sell a complementary  product as easily as your core. For example, an ecommerce company thinking that it can branch out and sell to the same clients advertising media.

2) Costs are usually at projections or worse above projections.

On the other side of the income statement, most startups manage to spend what they say they will spend. Unfortunately, when coupled with (1), this means many startups fail to hit their EBITDA goals. While not damning if they are growing fast enough, some startups do get caught and run out of cash.

Implications of the above 2 observations.

If the above 2 are usually correct, then it means that startups should always have a ultra conservative plan which requires them to project revenue at the worst case scenario and then spend at the worst case scenario. And be reactive enough so that if revenue comes in as expected, then ramp up the cost to match it. But never let cost ramp up in anticipation of revenue.

Now i know some people will say that is extremely conservative and startups that practise what i just suggested probably cant scale up super fast. Also, some people may also wonder how such a startup will get funded. I have 2 answers for this.

First, use your average to optimistic scenario for fund raising but use your conservative one once you get funding. This will solve your funding valuation issue and investors usually dont mind if the entrepreneur is more careful with their money.

Second, it really depends on market adoption or revenue growth. If market are growing like crazy (read over 100% per year), then yes, by all means ramp up the costs. But if market is still those that require you to educate clients (like job portals during the 2000-2003 days)... then perhaps it makes sense to pace costs to revenues.

Feel free to comment!

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