The pro forma quandry

In keeping with the $ and essentiality theme, in a pre-revenue early stage company it’s fun to think about future earnings.  By ‘fun’ I mean a thrill (thinking about the huge amounts of money we’re going to make), and sheer terror (thinking about how we are never going to make any money).  The normal roller coaster. Oh – and what that implies for your company in either scenario on the spectrum.

But from a pro forma standpoint, the thing that I struggle with the most – is the assumed relationship between sales/marketing activities and revenue.  Not normal operating costs (ie: rent), but money you need to apply to programs to help drive revenue. Here’s what I mean:

It’s often believed that the more money you throw at a marketing or sales program the higher revenue you will have.  Believing this notion is often independent of having decent product, although there may be an inverse relationship – the better your product, the less you spend on marketing, the worse, the more you spend (but I am pretty sure that’s irrelevant).  I think in general people believe that marketing dollars should be spent in relation to the amount of competition in the segment. Resulting in: if you spend x on marketing, you will get y in revenue.

One of the measures used I often hear (that illustrates the segment angle and the overall spend assumptions) is determining percentage of marketing dollars to revenue. Example: Yahoo marketing spend was 45% of sales in 2002, or Napster’s marketing spend was 80% of revenue in 2004.  But does this mean that the marketing dollars spent resulted in the revenue earned?  Could be, but maybe not. What if those are loyal/repeat customers – then does it apply?

I think the assumption that by putting money into a marketing you will necessarily drive an increase sales is not accurate. I think there is a correlation, but it’s not correct to assume causality. And if it’s not – from a pro forma calculation standpoint, how do you determine sales and what does an investment do to drive sales?

This issue is ultimately one of the key problems with pro-formas and why valuations are such a dark art.

Here’s our solution:  Base your pro formas on expected customer spend habits (either retail purchase, or CPM/click through) and determine what it costs to acquire those customers. So – if you can assume that you keep a customer for a period of time, and that customer will on average spend a certain amount, then you can determine your revenue fairly accurately based on the number of customers you have.

Then the real trick becomes determining customer acquisition cost (and that’s where the marketing dollars are important).  You need to both answer the question of what does is cost per customer to acquire and what does it cost to keep them.  Ideally your cost to keep is lower and ideally as you build a customer base your cost to acquire is lower.  

The notion of customer acquisition cost is not new of course. And it’s why viral is such a big deal: viral effectively reduces the cost of customer acquisition to zero.  That’s obviously important when you consider that in the early days AOL was spending something like $300 per customer acquisition. And it’s obviously important when you think of profit margin. And it’s critical when you are bootstrapping.

Now sadly, I don’t believe viral marketing is the right assumption to make for determine marketing spend to revenue. You can’t assume $0 cost for marketing. But I do think you can incentivize and facilitate viral expansion and get fairly close to an accurate read on cost per customer acquisition.  However, to be really accurate you need to have a little data from experience. In rVibe’s case – when we launch and start collecting data on our viral program conversion rates, we should be to do much much more accurate assessment of our projected acquisition costs.

And lastly, customer acquisition means nothing if you don’t have a revenue model and don’t know what people spend in that model. By nothing I mean “it will run your business in to the ground quickly.” Again, in our space, since there have been a number of surveys done in our space about average customer spend, we should be able to somewhat reasonably determine projected revenue. Once we have actual numbers we can work on driving that up (spend marketing $ to both keep existing customers and drive their spend up).

We’ll see (that’s what you always have to say after these discussions).

Posted on September 26, 2007 in Life in a startup, Management, Market

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