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Sanity check your business model!

Before you present your business model to a VC, make sure you do a sanity check and compare it against existing companies in your target sector.

From time to time I see business models that are flat out unrealistic – they either ramp revenues with a trajectory that NASA would envy or have pre-tax profits that are unbelievably high – for example ramping to $200M of revenue in three years or 70% profit (EBITDA). From time to time there are companies that generate extra-ordinary revenue growth but they are very rare and even the best of Wall Street's favorites top out around 50% pre-tax (and there aren't many of them!).

While an unrealistic business model doesn't necessarily generate an automatic "NO!" it's a credibility bust. It tells me that you haven't thought through the business model and haven't done your homework on how other companies in the same sector have performed.

Here are some suggestions that might avoid the credibility bust!

There is plenty of data available on how public companies have performed since their inception – visit the SEC filing data base and search for the S-1 filing – that will show you how much capital the company took in before filing to go public, how their revenue grew and more importantly, how their expenses were allocated. You don't have to look exactly like one of these public companies – times have changed – product development can be less expensive, sales models can be different etc., but the business model of a successful company is at least a proxy for the expense structure of your business. Don't just look at one company, look at several and understand where they are different and why.

The #1 bogus assumption I see in unrealistic business models? With a doubt, it's under-estimated cost of sales. Most folks come in with a good handle on the cost of product development and operations but tend to be wildly optimistic when thinking about the sales cycle, average sales and the structure of the sales force.

Once you have sanity checked your business model, make sure you capture all the assumptions you made in putting the model together. These assumptions show how you are thinking about growing the company over time. Make sure that these assumptions are realistic – I wish I had a dollar for every time someone used the phrase "this model is based on conservative assumptions" – only time will tell whether they are conservative or not!

In most of the presentations I see, the business model was generated using a spreadsheet – don't confuse precision with accuracy! Having a plan that shows the revenue and expenses to the last dollar is another dead giveaway of incomplete thinking.

Last but not least, don't get hung up on "perfecting" the model. It is ONLY a model. There are only two things you can say with certainty about the model:

  • It's wrong!
  • It's wrong in the wrong direction!

It's rare to see a business model that gets missed on the upside!

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STU PHILLIPS
MENLO PARK, CALIFORNIA

Intense Brit, lived in Silicon Valley since 1984. Avid pilot, like digital photography, ham radio and a bunch of other stuff. Official Geek.

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