(101) How to test the viability of a business model?

The traditional top-down approach for doing a business plan exercise is attaching your business model to a “large enough” customer segment. The next assumption is if you can capture “just 1 percent” of this large market, you’ll be all set. After all, 1 percent of a billion-dollar market is still a lot of zeros. And some business plans also talk about capturing all the way to 10% of market share.

I myself have worked in organizations where the business plan’s hypothesis was to capture 10% of market share. However, this assumption does not hold any water eventually.

Prior to this I had created a video episode on how to identify growth opportunities to pursue. But I had not gone into the minutest details:

I then read Ash Maurya’s Scaling Lean, which provided a good model to test if a business model is worth pursuing.

Ash Maurya highlighted that the problem with having a 1% or 10% market share estimates are many:

• First, it gives you a false sense of comfort. There is no foundational basis for the estimate,
• It doesn’t address how to get to this 1 percent market share with your specific product.
• 1 percent market share might not even be the right success criteria for you.

He offered a much better bottoms up approach for testing business models.

1. Determine your minimum success criteria

Let’s begin by understanding the minimum success criteria. Your minimum success criteria are the smallest outcomes that would deem the project a success X years from now.

Instead of thinking in terms of your business model’s maximum upside potential (like the 1 percent market share goal), it’s more helpful to time-box the minimum success criteria.

If you don’t have a reasonable minimum goal, it’s hard to define what success will look like. Not only are the minimum success criteria easier to estimate than your maximum upside potential, they also help you model your progress along the way.

Here are some guidelines for defining your minimum success criteria:

• Keep your time box under three years.

Anything longer becomes too far to see. The key is picking a date just far enough into the future that it allows you to demonstrate a working version of your business model. I have worked in large organisations where they made 5 year business plans and I always felt uneasy about it.

• Frame the outcome in terms of a revenue (or throughput) goal.

A yearly revenue goal more directly maps to the revenue streams listed on your Lean Canvas and keeps the model simple.

If you’d like to target a profit goal, use a gross margin assumption to convert your profit goal into a revenue goal. For instance, healthy SaaS products typically target a gross margin above 80 percent.

• Remember that the goal is a rough ballpark

You don’t need exact precision but an initial estimate with an order of magnitude.

First ask yourself whether you are aiming to build a $100K/year, $1M/year, $10M/year, or $100M/year business. You can then narrow a bit further from there.

2. Convert Your Minimum Success Criteria to Customer Throughput

Customer throughput is the rate at which nonpaying users are processed into paying customers.

• Pricing Model: In order to calculate the customer throughput needed, the first critical input we need is a pricing model. Most times Lean Canvases dont specify the pricing model. Even at the early ideation stage, you need to get specific on pricing. The biggest objection you often hear is: “How can I price a product when my solution is still uncertain? Price against their problems (using value-based pricing) and not what it’s going to cost you to build and deliver your solution (that’s a cost structure concern). You do this by anchoring against their existing alternatives, which should ideally provide evidence of monetizable pain.
• Again, precision here is not the goal but an estimate. First estimate to an order of magnitude. Is your solution potentially worth $1/month, $10/month, $100/month, “$1,000/month, $10,000/month? Then use your knowledge of your customers’ existing alternatives to get more specific.

At this point, it’s simple to figure out the number of active customers I would need to sustain my business model objective:

This is already a better number than the fuzzy $10M revenue goal because it makes the number more tangible. You can immediately test this number against your customer segment to ensure that it’s big enough.

While a number of active users is better than just a revenue goal, it still reveals only a part of the story. The danger of relying only on this number is that it’s easy to believe that all we need to do is reach this number of active customers one time and we’re set. But it does not factor in customer attrition or churn. Customers leave as a natural part of every business.

Another way of stating this is that the number of active customers represents the steady state number of customers that you need to maintain to sustain your throughput goal, but it’s not a measure of the rate at which you need to create new customers to replace those who leave.

To get this rate, we need to first estimate a customer’s potential lifetime, from which we can calculate their lifetime value.

ESTIMATING LIFETIME VALUE

Here are some ways to tackle estimating a typical customer lifetime:

1. Does your value proposition have recurring utility?

• One way to guess at the customer lifetime is through the nature of the problem you are solving. Is it a single-occurrence problem or something recurring? If recurring, how frequently would users need to solve the problem and for how long? From there you might be able to guess when they might outgrow your solution.

2. Think in terms of jobs

• Once you can clearly articulate the job your customers hire your product to do, it becomes easier to estimate the average time it might take to accomplish the job. “If you hire a painter to paint your house, you expect him to be done in a few days. If he is still there two months later, that’s probably a bad sign.

3. Study other analogs

• Studying other analogs in your vertical, or domain, can also be an effective way of estimating your average customer lifetime. In the SaaS world, for instance, Salesforce (the largest company in this space) reports a four-year customer lifetime. It doesn’t mean you can’t do better, but it helps to ground your own estimates.

4. If you are still stuck

If all else fails, pick a conservative estimate for now. A more conservative estimate for most business models is somewhere between less than a year (a one-time-use product) and five years.

Once you have a projected customer lifetime and pricing model, go ahead and calculate your projected LTV. For this business model, we can then calculate the required customer throughput rate as:

People usually have no problem calculating the number of active customers needed for $10M/year revenue, which we previously calculated as 16,000-plus active customers.

But the 8,000-plus new customers/year isn’t the number of active customers, but rather the number of new customers you need to make every year after you hit your minimum success criteria — just to sustain your desired throughput.

The point of this exercise is getting a first dose of reality on the viability of your business model.

What do you think about the viability of this business model now?

Creating 16,000 active customers one time is very different from having to create 8,000 new customers every year just to maintain your desired revenue goal

This part of the calculation, in the business model was the most insightful lesson for me. This lesson is going to remain with me for a long long time.