Tuesday, January 17, 2012

Lesson #105: Run a Sensitivity Analysis on Your Projections


Back in Lesson #78, we learned How to Build a Budget.  But, one important point that we did not discuss was the necessity of running a sensitivity analysis on your projections.  A sensitivity analysis is changing some of the key inputs driving your model, for both upside and downside case scenarios, to learn the impact such changes have on revenues and your resulting cash flow needs.  These key inputs could include things like: (i) your average price point; (ii) your gross margin; (iii) your cost of acquisition for marketing (and the resulting number of leads); and (iv) your sales conversion rate, just to name a few.

As an example, if your base case suggests you can build a $1MM business with a $100 price point and 10% conversion rate, your revenues would drop to $800K with a $80 price point, and would drop even further to $600K with a 7.5% conversion rate from there.  What felt like relatively minor changes to your price point and conversion rate in isolation, combined for a 40% reduction in revenues.  And, more importantly, if that $1MM business was break even before, with $1MM of expenses, it has now become a cash user, with a loss of $400K.  Since you most likely will not have excess cash sitting around to fund any losses, you should have a plan to raise outside capital if it may be needed.  And, as we know, fund raising can take months, so you need to be constantly thinking far enough ahead to ask for capital before you need it, and not when you need it (which is too late).

I think the key driver entrepreneurs mis-forecast the most is cost of acquisition for marketing.  Most entrepreneurs don't have a solid grasp on how expensive marketing activities are, especially for consumer facing businesses.  Building an internet business today is materially more expensive than building an internet business a decade ago.  As an example, iExplore could drive a profitable pay-per-click campaign with Google at $0.20 per click and acheive a first page ranking at that level back in 2001.  But, today, travel is one of the most competitive categories in Google, with many more competitors and big-budgeted brands like Expedia, Travelocity, Priceline, Orbitz, Trip Advisor, American, United, Hyatt and Marriott all fighting for the top positions for key travel words.  That has driven first page search result prices through the roof, to over $1.00 per click on most words, making it near impossible to drive an immediate profit.  Hence, allowing only well-funded startups or big brand marketers the luxury of getting easily found. 

So, pay extra close attention to your marketing forecasts and benchmark your business off of the cost of acquisition datapoints being realized by other companies in your space today, using the same marketing tactics that you plan to use.  That said, don't forget about the marketing benefits big companies get from trusted brand names built over time and years of optimizing their marketing tactics.  If Amazon.com's conversion rate is 10%, do not forecast your business at 10%, even if you are directly competitive with them and using the same tactics.  Amazon has been in business for 15 years and has a very well-known customer experience and respected brand name.  It would be much better to forecast your business at the average e-commerce conversion rate of 3%, or better yet, at a material discount therefrom given the inefficiencies you will experience in the early testing days of your marketing initiatives.

Sensitivity analyses can also be run for upside scenarios, if things go better than plan.  But, honestly, for 99% of startups, most things go worse than plan, not better.  So, don't waste time on upside cases.  If an upside case happens, congratulations, you'll figure out what to do with the excess cash at that time.

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