What we cover in this guide:
How startup finance is built around making a series of guesses around the costs and values we think are going to be true about our business.
The 3 most typical and important assumptions that can make or break the business.
How much revenue our startup will generate and how much margin will be left over to pay for operational expenses.
Let’s just start off by making one thing clear – almost no one understands how to forecast the future of a startup business. If somebody tells you they have a scientific model to precisely forecast the future– they’re lying!
Everyone guesses – and generally speaking – everyone guesses wrong. And that’s OK.
Startup finance is built around making a series of educated guesses about how things might go. We make assumptions for how much customers will pay for our product, how much it will cost us to acquire a paying customer, and how many times they will keep paying us over time. We make all of those assumptions to get us started. Then we find out we’re totally wrong. Then we make more adjustments. Then those are wrong too. Then we keep adjusting until eventually, our numbers are right!
That’s precisely what we’re going to cover in this Phase. We’ll also demonstrate how just a few main assumptions (like the cost of acquiring a customer) are really all that matters.
Understanding the “Assumption”
Think of assumptions as a placeholder value that we will use to begin building a forecast for our business. In most cases, our startup probably hasn’t been around long enough to know whether any of these values are accurate – and that’s OK.
For the time being, just know that all we need to build our first financial model is to know what the assumptions are and then make a reasonable guess as to what the values might be.
Forecasting (And Why No One Understands It)
In the early years of a startup, we’ll spend more time forecasting our business than tracking our finances. That’s because, in some cases, we won’t even have a business launched quite yet and therefore we’re working on a theoretical forecast for what will happen when we finally do launch. A financial forecast is just what we’d think it is – a guess about how the business might go.
The reason startups don’t understand forecasting is because they tend to think it’s based on information we have on hand right now. Forecasting isn’t intended to predict the future specifically. It’s intended to provide a working model to show us what happens when different assumptions we’ve made will change.
Let’s just think of our future forecasting as a simple “if/then statement”. “If” our costs per product are too high “then” we’ll need to increase our retail price to maintain the same margin. Our forecasts are just us moving all these levers until we find the right balance of revenue and costs for our business.
Assumptions + Forecasts
Our assumptions allow us to make really specific guesses about things like what a customer will pay or how much it will cost to produce the product. Our forecasts simply take those assumptions and calculate what will happen if those assumptions are true. Here’s an example of where just 2 assumptions can tell us exactly how much revenue we can forecast per month:
Assumption #1: Our average customer will pay $40 for our product.
Assumption #2: We think each month we’ll acquire 10 new customers.
“If” those assumptions are true “then” Forecast (automatically calculated): Each month we’ll add $400 in revenue ($40 per sale multiplied by 10 customers).
Notice how we are not “guessing” how much revenue we’re making each month. We’re making assumptions that lead to a forecast in revenue. By focusing our efforts on the assumptions (like how much the product will sell for, or how many customers we acquire, we can let our forecasts simply be a calculation.
Once we learn how distilling our business into assumptions gets us closer and closer to numbers that we can actually understand and predict with more accuracy, this whole business of guessing starts to become a heck of a lot easier!
With that said, let’s first dig into how assumptions work, and then once we have a handle on that, let’s see how those assumptions can build a forecast for us.
Every startup financial model is based on a handful of Assumptions which are the costs and values we think are going to be true about our business. Some of our assumptions will likely be:
How much will the customer pay for the product?
How much will it cost to acquire a paying customer?
What will it cost us per unit sold?
How many times will the customer purchase the product again?
Those are just a few of the most popular assumptions, but there are many. We’re probably thinking “How the heck could I possibly know what any of those values would even be?” and that’s the right question to ask! The answer is this:
❝ We don’t know exactly what any of these values are, but we know exactly which assumptions we need to have answers to in order to build the forecast.
We realize that’s like saying “We don’t know if this recipe requires a pinch of salt or a bucket of salt – but we know it needs salt.” In this case, we don’t know whether our product will sell for $20 or $40, but we know there will be a price for our product.
When we distill the formula down to specific values that we know we need to prove out (like the amount of salt in this recipe) it changes our concern from “what the hell is this recipe?” to “I know the recipe, now let’s just monkey with the amount of salt.”
So right now, let’s just focus on how assumptions work wonders for making our lives easier. Later on, we’ll focus on what actual values to use and how to make some sweet ass guesses!
The 3 Major Assumptions That Matter
Although it can be said that every business is a little different, the truth is most businesses still have to sell something to a customer at a price higher than what they paid. Within this universal truth lies a common set of major assumptions that nearly every startup uses to develop a successful financial model (or an unsuccessful one – the model is still the same).
We call these the major Assumptions that Matter. While there are TONS of other assumptions that will also matter in different capacities, we’re going to focus on the 3 most typical and important ones that can make or break the business.
The 3 most important Assumptions are:
How many customers will we acquire? (CAC). The first question we’ll need to answer is how many customers will pay us, and what that cost will be. If we spent $1,000 and acquired 10 paying customers, our Customer Acquisition Cost is $100 ($1,000 divided by 10). CAC is an incredibly important number for businesses that rely on marketing (not direct sales) to drive growth.
How much will customers pay us? (LTV). Next we’ll determine how much those customers will pay us by estimating the Lifetime Value of a customer. This is an indication of the total amount they will pay to us in a given time frame, such as a single year. If I buy one pizza for $10 and never buy again, my LTV is $10. If I buy 100 pizzas over the course of a year and we set “lifetime” to mean 1 year, my LTV is $1,000 ($10 x 100). LTV is really important when we want to understand how much long term value a customer has beyond an initial sale.
What is our cost of each sale? (COGS). Finally, we’ll determine the Cost of Goods Sold -- the hard cost of a single unit of the product. If we sell a bottle of water for $3 and we paid $1 to manufacture it – we have a $1 cost of the goods sold (COGS). We also way over-charged for a water.
When we’re done with this mystical math we’ll be able to determine how much revenue we’ll generate and how much margin will be left over to pay for operational expenses like salaries, rent, and those snacks in the break room. We’ll spend most of our time learning about these three and how they interrelate. We’ll also build some simple business models based on these that we can use to learn about assumptions and add our own later.
STEP 1: How Many Customers Will We Acquire?
Our first step is to construct a series of assumptions that tell us how many paying customers we will get through the door. To be clear – there’s no way we can know how many customers will actually pay us until we get our business up and running.
If our business is already operational, that may help seed some data to get us going, but ultimately this exercise is intended to tell us what the moving parts look like – not the perfect final answer.
The Goal is Conversions
Our goal in this exercise is to determine how many Conversions translate to a paid customer. A conversion is just a general term to mean that some potential customer has expressed interest in our product. We can modify how we think of conversions to include things like leads, sales, trials, installs, test drives or whatever translates into sales volume for our business.
What’s important is that we can take this final value (we’re using Total Conversions in this example) and multiply it by our average sale price in the next step to generate a total revenue estimate for the business. In order to get to total conversions we must build up a list of assumptions that lead to that number.
Let’s assume our business relies on driving traffic to our website to generate sales. In this case, we’ll assume that sales happen directly on our website. If they didn’t, we might add some additional assumptions to determine how many customers convert later in the process, but ultimately, we want to know how many paying customers we will have.
Here’s the list of assumptions we’ll use. We will input values in blue – the rest is just a calculation.
How many paying customers will our Web arketing create?
How many visitors will our budget get us?
According to these assumptions, if we spend $1,000 on marketing, we’ll generate 60 paying customers. Let’s walk through each of the assumptions one-by-one to figure out why we chose these specific values and how to modify them to our own tastes.
Before we move forward, look at what we just did. We used two assumptions (Budget, Cost per Visitor) to drive our Total Visitors. Within those two assumptions, one we have some control over (Budget) and the other we’ll have to try to manage toward (Cost per Click).
There’s an important difference when we’re building all of these assumptions around those that we have some measure of control over (like Budget) and those that may get out of hand (like Cost per Click). Building and managing assumptions as a startup team is all about saying “here’s what we think we can control, and here’s what we’re pretty freaked out about!” Not all assumptions are created equal.
How many of those visitors will become paying customers?
Now that we know we’ve got 2,000 Total Visitors, we need to build an assumption around how many of those will turn into wonderful paying customers.
Conversion Rate. What percentage of website visitors will turn into paying customers? (“How the hell should I know?!” we might ask) That’s the million-dollar question. The truth is we don’t know that answer until we have enough data to support it. What we need to do is insert a value (we used “3%”) as a starting point to generate our Total Conversions (to a sale). We’ll get back to this in a minute. All that matters now is that we agree the number is crazy important.
Total Conversions (to sale). This is the big payoff – and there’s no assumption here either. All that is happening here is we are multiplying the Total Visitors (2,000) by the Conversion Rate (3%) to get 60 Total Conversions to a sale. Yes! We have 60 paying customers!
In this model if our assumptions hold true, $1,000 of ad spend will generate 60 paying customers.
What’s more important is what we can do with these assumptions going forward. Instead of saying “I don’t know how many customers we could possibly get!” instead we can say this:
If we spend $1,000 and have a $0.50 cost per click – we will absolutely have 2,000 Total Visitors.
If 3% of our visitors convert – we will absolutely have 60 paying customers.
All we have to be concerned about is getting to a $0.50 Cost per Click and a 3% Conversion Rate. The rest is just math. All of our time will be spent trying to manage these assumptions.
Customer Acquisition Cost.
Earlier we mentioned a critical assumption known as Customer Acquisition Cost (CAC). We’re going to get asked about this about a billion times if we talk to investors, so let’s make sure we know what we’re talking about here.
CAC is the total cost to acquire a customer. That’s the simple version. It gets a little bit more complex when we start asking, “Well does that mean a lead, a trial, a paying customer – what?” This can sometimes be interchangeable, but for the sake of this discussion, let’s talk about the cost to acquire a paying customer.
We spent $1,000 in our budget. We got 60 Conversions to a sale. Our CAC is our budget ($1,000) divided by our Conversions (60) to equal $16.67 CAC.
When someone asks, “What’s your CAC?” they are really implying, “Are you spending more per paid customer than you’re making?” or “Is your cost to acquire customers really high compared to how others in your industry are doing?”
We’ll want to pay attention to our CAC because it directly impacts our ability to keep spending more money on marketing. If our CAC is $16 and our product sells for $9 – we’re in trouble!
This seems Too Easy! Can We Please Make it Complicated?
Chances are there are some steps in between those assumptions. For example, our Conversion Rate may first represent the number of people who became a Lead (maybe they only entered an email address to subscribe to our mailing list). Then later some percentage of those people would turn into a sale.
We might modify our assumptions to look like this:
In this model we began calculating our Leads first from our Total Visitors. Why? Because we may have more activity initially around leads (people sign up before they ever become a Sale). Therefore we want to isolate the lead conversion number first, so that we can focus on the variability of the conversion rate to sales later.
We typically add more assumptions so that we can focus on a more detailed number. It’s probably harder for us to understand how 2,000 random visitors turn into final sales. But it’s easier to understand how 200 Leads convert to a Sale – because there are less of them, and their intent is much higher. We have a lot more data on them (like where they came from, where they entered their information, or what they told us) so that we can manage that next assumption (conversion to a sale) much easier.
That’s it. As we discussed, what matters is that we have a series of assumptions to determine how many paying customers we might have. Once we know how many paying customers we have, we can move on to the next step to tell us how much they might pay us.
STEP 2: How Much Will Customers Pay Us?
Now that we have some assumptions set up to tell us how many paying customers we might get, the next step is to figure out how much they might pay us. This begins the fun journey of determining our LTV – or Lifetime Value.
How can we calculate the “Lifetime” value of a customer when we’ve just begun building the business? That seems very premature. Well, that’s what this whole section is dedicated to. This is the question that really matters - how much people will pay us.
The LTV Formula – Clarified!
The reason LTV is so important right now (even though we have no idea what it will ultimately be) is that it drives so much of the rest of our model. For example, if our customer – “Greg H” – buys a single pizza from us for $15 and never buys again, we know we can never spend more than $15 (really, a lot less) to acquire him as a paying customer. We can already see where this would impact our maximum CAC from the previous step.
But, if our friendly pizza-loving Greg H were to buy 3 more pizzas – we’d have $60 of total revenue – which would give us more profit margin to play with to acquire him.
So, it’s not just about a single purchase driving our business model, it’s about the entire value of all a customer’s purchases.
In the event it’s not obvious, that’s because we tend to only pay to acquire a customer once. That doesn’t mean we don’t have additional cost in bringing a customer back again, which we may also add to our total CAC, it just means that when we try to build a forecast for our business model, we want to focus on keeping our CAC lower than our LTV.
In order to calculate the total value of a paying customer (LTV), we just need to know the average amount they will pay us, multiplied by the number of times they will pay us.
By now there are likely a few frequently asked questions that may be looming already. Let’s try to pick those off before we dig in further so that it’s not distracting.
What if my customers don’t recur? No problem. If we only sell one time to each customer then our LTV is the same as our Average Order Value.
Does the AOV change as customers spend more/less over time? It does. We can go back and update our LTV based on new activity. Right now, we’re just using the recurrence against a single AOV in order to get a rough forecast.
How long is “lifetime”? That’s up to us, but it can either mean the entire lifespan of a customer (over many years) or it can be adjusted to a window of time (only this year).
Assuming we’re good with those concerns, let’s explore each of the moving parts that get us to LTV.
Average Order Value (AOV)
Our first step is to determine our Average Order Value, which means what the average customer spends with us per transaction. For our purposes here, we’re going to focus on how much they spend in their initial purchase and then multiply that across the number of times they recur. That’s just because for now we’re still guessing at how much they will spend over time, so we’re trying to lock in a few variables.
Here’s how we calculate Average Order Value:
If this month we generated $2,000 in sales among 100 first time customers, our Average Order Value (AOV) for a first-time customer is $20 ($2,000 divided by 100).
Again, over time we will learn more about our average order value, especially with businesses that have a great deal of variance per customer, such as retailers. Regardless, the AOV will still reveal itself over a period of time as an average. For now, we can just pick a single value with the intent of modifying it over time.
Recurrence is the number of times a customer will purchase our product again. Most businesses have recurring customers, and many business models rely on recurrence in order to get the full value out of their customer (and pay for the costs of servicing them).
Netflix is a great value at less than $15, but if every customer only paid a one-time fee of $15, the business would die a quick and painful death! Therefore, Netflix relies on customers to keep paying month over month (recurrence) in order to cover their initial costs to acquire the customer, and of course the ongoing costs to pay for content and the operating parts of the business.
Our customers don’t have to pay on a monthly subscription basis for us to consider them to be recurring. The recurring aspect can happen in any time frame. What’s important is that we know how many times in the given time frame they might recur.
For our purposes, let’s use a one-year time frame. There are plenty of reasons we may need to extend that time frame, particularly if it takes a really long time to recoup our costs, but unless we see a strong need to extend our timeline beyond a year, let’s focus on what happens in a single year for now.
How to Forecast Recurrence
If our business has never operated before, like anything else in this business model, we’re going to guess how many times a customer might recur. What’s important isn’t the value that we use, but the impact that we see this particular assumption has on our business.
The best way to start is to just use an educated guess based on how we think the customer might recur. This gets a little tricky because we have to guess the average number of recurrences. Yes, one customer could buy a pizza from us every day, but how many will the average customer buy from us in a month?
We may come to this conclusion: The average customer will likely buy a pizza from us once every other month. Some will buy a couple of times per month and others will only purchase one pizza ever, but we’re estimating that our average customer will buy about 4 pizzas per year. Our recurrence is 4 units.
Over time as we adjust that figure we will notice a massive impact on our business. The moment recurrence jumps to 8 units we nearly double our revenue per customer, allowing us to market even more aggressively. There’s a whole course to be written about recurring business models, customer retention, and churn rates. But suffice to say, this one is really important.
Lifetime Value (LTV)
If we know how much our customers pay on average (AOV) and we know how many times they will pay us again (recurrence) – then LTV is just simple math: Average Order Value ($15) multiplied by Recurrence (4) = Lifetime Value ($15 x 4 = $60)
Note that we count the first order as “recurrence” as well. If the customer purchased just one time, the “recurrence” value would be 1.
What LTV Tells Us
Now that we know our average customer will yield us $60, we can use that information as the foundation of our financial forecasting.
Now that we have a nice handle on “how much will they pay us?” we are ready to move to the third step, which lets us know how much we think the product will cost us – Cost of Goods Sold (COGS).
STEP 3: What is our cost of each sale?
We already know how many paying customers we have as well as how much it will cost to get them. Now we need to make sure we can deliver the product cost-effectively by determining our Cost of Goods Sold.
Cost of Goods Sold (COGS) is the amount it costs to ship a single unit of the product. Before we dig into the assumptions of COGS, let’s talk a bit about why breaking out COGS matters to begin with.
Our goal with COGS is to separate our business costs into two buckets – Dynamic Costs and Fixed Costs.
Dynamic Costs increase every time we sell a product (basically COGS). If we sell 10 more pizzas we need more bread, sauce, and delicious cheese.
Fixed Costs mostly stay the same whether we sell 0 pizzas or 100 pizzas. This includes things like office rent or monthly bills we pay to a gazillion software vendors.
This is important because our business is largely driven by how our Dynamic Costs change with the growth of our business. When we’re forecasting for the year, we need to know exactly how our marketing will drive more customers, how more customers will lead to more sales, and how much it will cost us as those sales increase.
If we pay ourselves $50,000 in salary per year, whether we sell 10 pizzas or 100 pizzas our salary won’t change. That means we’re not a dynamic cost - we’re a Fixed Cost. We may need to hire another person once we are selling 1,000 pizzas, but that’s just operational growth. What we care about right now are the specific costs of every unit of pizza sold.
The FAQs on COGs
Most new Founders ask the same questions about COGs so let’s try to wrap them up before we spend time determining where and how COGS will affect our business model:
What if we have no real COGS? There are tons of businesses that don’t have any meaningful COGS. Most software businesses don’t recognize COGS because the cost of an additional unit of sale is near zero. If that’s the case, our emphasis will likely be on CAC and LTV without having to factor COGS into the equation. Incidentally, it’s also why software-based companies like Google and Facebook make so much money.
Are people (staff) considered COGS? If our business requires us to pay staff directly to deliver the service, then yes. For example, a service named Zirtual offers virtual assistance to busy Founders and each customer allocates a percentage of the assistant’s salary as the cost of delivering the service. (Most consulting businesses work this way because the “product” is the staff – quite literally.) We don’t want to confuse that with “we pay people to build the product.” If we’re thinking about our pizza place again, the staff isn’t the product. If we sell 10 pizzas or 100 our staff earns the same amount, and therefore while they are making yummy pizzas, the cost of the pizza is the dynamic part we want to capture.
Is marketing considered COGS? Nope. Marketing is very much a dynamic component to most startups, yet we’ll want to keep it separate because it can go up or down regardless of whether we sell anything at all. COGS only comes into play when we actually sell something (or get stuck with inventory)
If we buy inventory, is the COGS the whole cost or “per unit” cost? If we pay $1,000 for a case of energy drinks that we’re going to sell, our COGS should still be considered on a unit basis. So if we sell one drink for $3, and we paid $1 per unit, our COGS that month is $1. That’s for this specific purpose of forecasting and building a basic income statement (which we’ll cover later). There will be some different accounting that takes place when we need to manage our Balance Sheet, which is where we keep track of all of our overall cash costs, regardless of whether we sold anything.
If we have a use case that still doesn’t seem to be covered here – it’s best to use our best judgment. A lot of this forecasting and assumption building is to create a framework for making decisions, it’s not a test to see if we can follow some stringent guidelines. Let’s save that for our income tax returns.
With our biggest 3 assumptions in hand, we’re ready to move onto the wonderful world of forecasting. We’re going to start taking the values we discussed throughout this section and build out a financial forecast that will tell us a bit about how our future might play out.
What’s nice about this process is that we can simply tweak each of the assumptions and the forecast will change accordingly. This allows us to take into account lots of tiny changes to our assumptions that can lead to a significant impact into the viability of the business.