When exploring the feasibility of your business, pretend you are the investor. Actually, it’s not that far from the truth—you are about to invest years of your life, and most likely your life savings, into this high-risk venture. You want to be sure this is the right opportunity. Among other things, an investor usually conducts at least a month of due diligence before making an investment decision. They will ask tough questions: Is the market large enough and growing? Why will customers buy? How big is this financial opportunity? Is this the right management team? How do they think about the product and industry? Ask these tough questions (and many more) of yourself. Does your idea withstand the scrutiny?
If you find this process difficult, find a savvy investor in your area and pitch him. In addition to great feedback, you’ll be able take a step back and see how an investor would look at your business.
Like buying a house, starting a business is a very emotional process, and it’s easy to lose sight of the fundamentals. Looking at your business like an investor will help you get into the proper mindset, so you can evaluate the opportunity dispassionately.
Cash is king. The cash dynamics of your startup are often a make-or-break aspect of your feasibility study. There are two sides to cash, what you take in and what you pay out. The two should be evaluated independently. Since cash coming in is usually a distant dream at a company’s founding, focus on the outflows. To illustrate the point, consider your sales cycle, or how long it takes to sell your product to potential customers. There are some businesses with months-long sales cycles. Imagine the cash implications of this long sales cycle—you have to cover the overhead for months while your team is burning cash, struggling to close sales. There are a bunch of similar cash-related activities that are easy to overlook but crucial to feasibility. Poor cash management will bury your business. Take each assumption in turn, consider the cash implications, and project out your cash requirements. How much cash do you burn before you get to breakeven? Adding up the monthly losses will tell you how much money you’ll need to build the company.
In the early days of a startup, entrepreneurs have a tendency to make pricing their products or services much more complicated than it needs to be. Fundamentally, the price you charge is a function of value and competition. First, consider what kind of value you create for the customer. If it’s an enterprise, this should be a Return on Investment (ROI) calculation, or the amount of money you can save a company when it uses your product. Consumers are more complicated, as they value intangibles like luxury, status, brand, and entertainment value. Once you have a rough idea of value, use competitive and substitute offerings to triangulate a potential price range. Then consider where on that price range your product fits best. One great tactic to help uncover price sensitivity is to interview potential customers and ask them if they would use your product if it were free. If they say yes, then ask if they would purchase it for an outrageous amount (such as $1 million). More often than not, your customer will say something like, “Of course not, there’s no way I would pay more than $150 for this.” Bingo, you’ve got your price!
Now that you know the acquisition cost of new customers you can compare that to the Customer Lifetime Value (CLV). The CLV is the total amount of money that an average customer will pay you. For example, if you charge $30 per month for your service and the average customer is retained for 10 months, your CLV is $300. If CAC > CLV, you won’t be in business very long. If CAC = CLV, then you won’t make any money on these sales, and again, you won’t be in business very long. This strategy might make sense in the short-term to build a customer base, but it’s not sustainable in the long run. The best situation, and a metric to work towards, is for the CLV to be at least double the CAC (CLV >= 2 × CAC). This cushion gives you the ammo you will need to expand your marketing efforts and sustainably build a solid customer base. Obviously, the more cushion the better. These metrics will be hard to know with any certainty before you launch, so make educated guesses and monitor your progress closely. The bottom line is that you don’t have a feasible business if it’s too expensive to reach your customer given your prices and margins.
How hard is it to reach your target market? Do you have to search for customers or will they find you? The average dollar amount spent to land a new paying customer is called the Customer Acquisition Cost (CAC). If you hire a salesperson who costs $1,600 each week and she lands four customers per week on average, your customer acquisition cost is $400. On the web, if you pay for Google Adwords at $2 a click and it takes 30 clicks to get a user to sign up, your cost is $60. Different market segments vary widely in how challenging they are for companies to reach. Some audiences are impossible to find, whereas others have obvious and cost-effective channels. The harder it is to reach potential customers, the higher your acquisition costs will be. As a startup with limited resources, you have to plan your initial targeting carefully because a high acquisition cost can quickly break the bank. Underestimating the CAC bankrupted eToys, a dot-com company valued at one point in excess of $4 billion. Try to estimate your CAC up front to see if it makes financial sense. If you find that the CAC is too high, experiment by either targeting different channels or different segments. The CAC is a vital startup metric for you to analyze and monitor continuously.