If you’re anything like me, there’s few activities you love more than modeling your business in Excel. The rush of adrenaline pulsing through your veins while staring mindlessly at a blank spreadsheet.
Few experiences match the intensity of such a moment.
In college I studied business, so when I started working with startups I was always tasked with creating revenue models and forecasts. I’ve done this activity on many occasions for a variety of different businesses. Everything from a mobile streaming app, to a marijuana grow operation.
In all honesty, I’ve done it so many times that I almost find the process meditative; which, isn’t weird at all.
Revenue modeling is a helpful exercise, as it makes you think about the details behind the different components of your business and how they fit together. After a while, I began noticing similarities between different business types, and wanted to share some of my insights with you.
At first, I didn’t know what the hell I was doing. I was frustrated, embarrassed, confused and scared. All things I want to help you avoid. There isn’t a lot of great information available describing the thought process behind revenue modeling, so my goal is to create the roadmap I wish I would’ve found when I first started.
After you’re done reading this post, you’ll have a better understanding of how to think about your own revenue model, and how you can prioritize important activities to drive better returns.
There are many moving parts within a business, and building a revenue model forces you to think about the details behind how you’re going to execute each phase of your plan.
This process helps you identify things like how many customers you’ll need to break-even, or whether your price point is sustainable given expected growth rates. Things you’ll want to know. Especially if you’re going on SharkTank.
A solid revenue model starts from the bottom, and illustrates the specific activities you’ll do to get new customers.
It’s not enough to say “we’ll capture 10% of a $5B market.”
Where would you start? What specific steps will you take? These are some of the questions your revenue model should answer.
This way, if done correctly, you’ll have a good idea of whether the economics behind your assumptions make sense before you waste any time.
Too many entrepreneurs put this off until they need to raise money, or worse, when they’re trying to dig themselves out of the mess caused by executing on a poorly conceived business model.
I’ve done this myself, and one of these experiences even led to the inspiration for Poindexter; but that’s a story for a different post.
Ultimately, your revenue model represents the various offensive attacks in your playbook. Once things start going sideways, it’ll serve as a powerful tool to help adapt to new scenarios, and make informed decisions that move the yardsticks forward.
“You need to have a plan even for the worst scenario. It doesn’t mean that it will always work; it doesn’t mean that you will always be successful. But you will always be prepared and at your best.”
- Bill Walsh
Before we dig into the weeds, it’ll be helpful to understand the difference between a revenue stream, and a revenue model.
In short, a revenue stream represents one of the specific ways you’re making money (i.e. sales from a single product). However, a revenue model is the combined sum of all your revenue streams put together.
As an example, if we consider the pricing model of Stripe, they charge a flat rate per transaction, and a percentage of the overall amount. On their income statement, they may want to have both of these broken out as two separate revenue streams. The reason they’d want to do this is because the flat rate indicates the volume of transactions, and the percentage fee would tell them the total currency volume. These revenue streams taken together would then make up their revenue model.
We’ll discuss the specific components behind each revenue stream and how they can differ from business to business as we get into the Transaction Type section below.
Very few products are able to sell simply because they exist. So, one of the first things we’re going to consider is where, when, how, and in what quantities we expect to acquire new customers.
Pro tip: Start talking to potential customers before you’ve finished the product.
Lead generation is the part of the revenue model newer entrepreneurs often think about least, but it’s THE most important piece.
This is yet another mistake I’ve made; this time when starting Poindexter.
It’s easy to get caught up building the product, but if you don’t start recruiting prospective customers from day one, no one will know to use your amazing tool, and you’ll feel like you’re trying to catch up for a long time.
This is why it’s important to start by researching where you’re going to find prospective customers.
Your strategy should consider factors like who your target customer is, where they hang out, how you’ll reach them, and what you’ll do to gain their trust. All these things need to be aligned and reflected in your revenue model.
As an example, it seems unwise to try and recruit new customers by setting up a booth at a PETA rally to market the latest fox-skin romper.
A lot of thought and research needs to go into the strategy behind lead generation.
Also, keep in mind that at first it may make sense to do things that don’t scale. This will give you a chance to be more hands-on in the customer development process, and validate some of the assumptions you’re making.
Start by building a list with each of the sources you’ll target; the more specific, the better.
Then, estimate how many leads you think can be generated each month for every channel. Sometimes information about audience sizes will be available. Sometimes you’ll have to base it on some general level of activity. Just start with some justifiable numbers.
Next, specify when, and for how long you think you can drive leads from each source.
Let’s be honest with ourselves. We’re probably not going to generate 10,000 leads per month for a year from a single blog post discussing our favorite West African sea mammal.
It’s important to back our initial assumptions with data whenever possible.
Once we’ve detailed all of our sources, and we have a baseline number of leads forecasted each month, we should have something that looks like this:
Hopefully your list is more detailed than this.
The next step in developing our revenue model considers the journey each lead takes before converting into a customer; if they do at all.
This is where our assumptions will really be put to the test, because although there may be information available about how many leads we can expect from individual sources, there’s often no pre-existing information about how effective our sales copy is, or whether people want to buy our product in the first place; at least for new businesses.
You can always throw leads at a product, service, website, or app, but if no one is converting it’s time to take a long look at where our assumptions are going wrong.
Maybe we’re targeting the wrong audience, or perhaps we’re not highlighting the right benefits.
These situations highlight the importance of keeping an eye on conversion, so we can adjust our plans as events unfold.
Find some metrics you’ll be able to use as a proxy for tracking conversion, then go ahead and establish baseline conversion rates for each acquisition channel.
Revisit these assumptions periodically to see whether they match up to reality. If they don’t, update your model and figure out whether you can invest resources to realize better returns.
When we started generating traffic for Poindexter, we noticed sending cold emails to CFO’s was getting us nowhere. Even after we finally managed to score a few meetings, it was clear our product wasn’t going to be for them.
On the other hand, we were doing much better with entrepreneurs, so we refocused our efforts toward getting featured on startup discovery platforms, tool stacks and app directories. This started to move the needle… a little bit.
Once you begin executing on each customer source, if you’ve prioritized them by potential, you’ll likely need to reassess your strategy when it comes face to face with reality.
We’ve now completed one of the most important parts of our revenue model, which also happens to be the part we’ll need to focus on most, at least early on. From here, the structure of our model should be more stable over time.
One of the more significant realizations I had regarding different revenue models is how they simply consist of a combined set of various transaction types. When we consider these transactions individually, they’re fairly straightforward.
Ultimately, your business needs to get paid - unless you’re Twitter - and the primary differences between revenue models comes from the details behind how, when and why each transaction takes place.
How is the transaction structured? Is it a flat rate, based on a percentage of volume, or something else?
When in time do transactions take place? Is there a free trial? Are payments recurring, or is it an upfront transaction?
Why is the transaction taking place? What triggers it? Does it support the structure of the value delivered?
Below, you’ll find a general breakdown of the different transaction categories I’ve encountered. Most of the revenue models I’ve stumbled across fit into some combination of these transaction types. It’s not to say this list covers every scenario, but it should be enough to give you some idea of how to view the monetization piece of your revenue model.
Description: The most straight forward transaction type. It occurs between two parties that engage in an agreement, where one party receives compensation in exchange for providing goods or services to the second party.
Revenue Model Examples: Retail, E-Commerce, Manufacturing, Content Upgrades, Flat-rate Services, Project or Agency Models, Donations, In-App purchases, Wholesale Revenue, Mail orders, Razor and blade (Razor part), 2-Sided Marketplaces
Description: This transaction model is based on the idea that one party compensates another for access to goods, services, features, facilities or other forms of property for a predetermined amount of time.
Example Revenue Models: SaaS, Subscription boxes, Co-working spaces, Car Rental, Apartment Rental, Leasing
Description: Usage based transactions can involve 2 or more parties, where the owner of a property is compensated based on another party’s usage level of that property.
Example Revenue Models: Advertising Revenue, Mobile Phone Service Provider, Hourly services, Cloud service providers, SaaS, Subscriptions, Razor and Blade (Blade part)
Description: Indirect transactions involve at least 3 parties, where a third party receives compensation in the event of a successful agreement, interaction, or transaction between the other two parties.
Example Revenue Models: 2-Sided Marketplace, Affiliate / Referral Commission, Licensing revenue, Franchise revenue
You’ll notice that some example revenue models are included in more than one category. This is specifically to illustrate that they aren’t mutually exclusive, and there’s a grey area in between each one. This list is just meant to be a general guideline.
How you’re delivering value to customers should be the primary consideration driving your decision behind the combination of transaction types you use.
Now we can start building our monetization model around the how, when, and why of each transaction. The easiest method to demonstrate is the direct model, so we’ll use this method for our example.
We’ll start by establishing our parameters around the how, when and why.
To keep things simple, we’ll assume that each customer we acquire is charged a flat rate (how) immediately upon converting (when) for purchasing a pair of environmentally friendly plastic sandals (why).
Because leads convert into customers immediately upon purchasing the sandals, we can simply multiply the number of customers acquired each month, by the price of the sandals to get our revenue forecast.
To take this example a step further, lets also assume that some percentage of these customers will return each month to purchase another pair.
In order to accommodate this new assumption, we’ll need to keep track of our customer base.
What we’ll do is create two new line items. The first of which is the “Beginning Customer Base,” which represents the number of customers we have at the beginning of each month. The second is the “Ending Customer Base,” which is the number of customers we have at the end of the month.
As we acquire new customers, we’ll add them to our base from the beginning of the month to arrive at the total customer base for the month.
Think of it like an email list. As new subscribers sign up, they’re added to the total number of existing subscribers.
Lastly, although it would be nice to assume our customer base is going to grow infinitely, it probably won’t, so we’ll need to introduce our last parameter, called “Churn.” This is the percentage of our customer base that leaves each month; never to return.
Now, I don’t know why they’re leaving. Maybe the sandals aren’t very comfortable, or these customers are moving far away, or possibly they find out plastic sandals aren’t environmentally friendly. It’s anyone’s guess.
In any event, we’ll need to subtract these people from our base to make sure we don’t over represent the revenue from returning customers.
We can now simply multiply the number of people in our “Beginning Customer Base” each month by some percentage to see how many returning customers we expect to come back and purchase more sandals.
When it’s all said and done, we should have something that looks like this:
Next, all we have to do is add the revenue from new customers and the sales generated from returning customers to complete our revenue forecast.
When we consider the other revenue models things become slightly more complex, which means we’ll need to add more parameters.
For instance, with the usage based transaction model we’ll have to assume some level of… you guessed it, “usage.” So, if we’re selling razor blades, we’ll need to figure out how many blades we’ll sell with each purchase, and how long it takes customers to go through those blades before they return to purchase more.
The modeling process for the other transaction types will take a slightly more sophisticated knowledge of spreadsheet equations, but that’s beyond the scope of this post, and is something a few YouTube videos can address more effectively.
I hope this was a useful guide in providing a framework for the thought process behind your revenue model, and how to go about tying specific activities to financial outcomes. Now all we have to do is put this plan to use.