When raising investment, a realistic and flexible financial model is an essential part of your business documentation. Investors want to know why you are raising investment so it is important to get the financials right. The following blog is the third and final of a three-part series on getting investor ready, aimed at companies who are planning to raise Seed investment in the B2B industry.
InterTradeIreland’s Lead Equity Advisor, Drew O’Sullivan shares some valuable insights into why decisions on pricing, margins and cash flow generative models need to be carefully considered before seeking investment.
Over the past nine years, shares Drew, I have met with over 1,350 start-up entrepreneurs in one-on-one equity advice clinics and discussed their business model and fundraising plans. I have also managed accelerator programmes, as well as spending a few years as a venture capital investment manager. So while this is not a comprehensive expert guide on business models, with definitions and examples, it is based on observations that reflect that wide and varied experience.
While the decisions explored below come under the heading of a company’s ‘business model’, they are areas which are often under-appreciated by start-ups when having pre-seed or seed fundraising conversations with prospective investors, but it is important that they are considered.
Pricing & Margin
Increases possible valuation
There is a well-known McKinsey article on pricing (The Power of Pricing, 2003) which highlighted that for public companies, if they can increase their pricing by 1% and demand does not fall, they can increase their operating margin (EBITDA1) by cerca 8%. As most public company valuations can be reflected as profit multiples (P/E2), this means that if a company can achieve these changes to their pricing, without affecting demand, it can increase its valuation by cerca 8%. Start-ups should be aware that pricing will leverage their ultimate exit valuation.
Influences investment attractiveness
The choice as to what is the optimum price to charge customers is not an easy one. Improving gross margin percentage is usually more a function of increasing price, than being able to hammer down direct costs. Being able to optimise your pricing to improve your gross profit margin can have a significant impact on both your cashflow (additional contribution to cover overheads) and your valuation on a potential exit (so it interests entrepreneurs and investors even at the start of the journey).
I appreciate this is a broad-brush statement, but the higher a gross margin percentage a company can justify/achieve, and potentially sustain (while fighting off competitors etc), the more attractive it might be to investors. There are some early-stage investors who will not even consider investing in a company where the gross profit margin is under 50% (or even 60%).
Value Based Pricing & Positioning
Some start-ups position themselves as entirely unique with a focus on a customer segment who will find their offering extremely compelling. Yet, when they articulate how they arrived at the pricing decision – suddenly they benchmark themselves as 10% over/under their nearest competitor (no real clear differentiation really exists then is the signalling impact of that price decision). Pricing cannot be picked out of the air – but ideally if a start-up can demonstrate measurable economic benefit for a customer, and base their pricing as a fraction of that, they can use some level of value-based pricing. “Premium” pricing with high gross margin signals competitive differentiation.
Market Sizing – scale of opportunity
Often for start-ups, their market sizing is based on multiplying a theoretical number of customers by an average price they hope might be achievable from each customer. If the start-up anchors itself with low pricing (and I have seen this very often) – it directly impacts how they communicate the potential size of the market. This may result in an entrepreneur scoring an own goal in a pitch meeting.
Cash Generative Models
Upfront cash receipts
Not enough start-ups look at the alternatives to raising third party capital to scale their businesses. There are many very well-known start-ups, which managed to design their business model, particularly in the early years to be cashflow positive. While some of them may have gone on to raise capital to scale subsequently, the essence of the model was getting paid upfront before having to pay outgoings. John Mullins’ The Customer Funded Business is well worth reading for more examples of these types of businesses.
Product Good, Services Bad?
One of the perceived no-nos in the start-up world is having any service component in delivering value to customers – it has to be product or it won’t scale, is the mantra. However, looking at the gross margins of most of the largest SaaS companies on the Nasdaq, they hover around 75% – so clearly, there is more going on than simply a pure 99.9% software gross margin contribution for each additional customer onboarded. Several well-known technology businesses with significant service component have scaled off this island – OpenNet, First Derivatives, Norkom, Fenergo, Kainos etc.
Service Pricing is critical
Services as part of your business model may be necessary in any case, as many customers will require it for some offerings. The flipside of this is it allows a start-up to gain more insight and cement stickier relationships potentially. The key is to make sure you get paid enough for it and that the blended margin between product and service is as high as 75%. Remember, for many start-ups they are the only ones who can actually provide much of the services around their product (customisation, integration, onboarding, training – or the all-encompassing “customer success”). So the start-up has a monopoly in effect on delivering the service – they should therefore price accordingly.
In summary, paying attention to your financial model is key for start-ups seeking investment. The financial model of your business converts your business plan into a realistic set of financial projections which will make your business more attractive to potential investors.
Further advice for start-ups
If you need more advice on raising finance, you can avail of our Equity Advisory Clinics. Hosted by lead equity advisor Drew O’Sullivan, companies can receive free one-to-one advice on pitch practice, equity investment, fund raising and a review of their business plan.
For start-ups and early stage businesses the Seedcorn Investor Readiness Competition is the perfect chance to get ‘investor ready’ and mirrors the real-life investment process. Participants, who are in with a chance to win a share of a €300,000 cash prize fund also win with free mentoring on how to pitch to investors, free advice on what investors are looking for and free insights on their business, all while boosting their firm’s profile. To find out more and to apply visit www.intertradeireland.com/seedcorn
1 EBITDA - earnings before interest, taxes, depreciation, and amortization (used as an indicator of the overall profitability of a business)
2 P/E- price to earnings ratio.