Business Models The New CFO

The New CFO – 02 Validating the OpModel

Part two of “The New CFO” series on my blog. After introducing the new CFO as the master of capital allocation or internal investor of the company into spending portfolios, we want to look at what it means to validate a segment – or to establish product market fit in a segment – and what it means to validate a business model. Then we can understand how the new CFO is the person to track the progress on validation using a solid operating model, or OpModel. And what he needs to advocate to make the business work.

The operating model intro

Gone are the days where you are running a business based on net present value of projects or business lines. The typical investment calculation that is in principle a project ROI calculation, is dead. Or at least, it lives in a new world.

The new world is the operating model of the organization. And the operating model has to show some very simple things.

  1. It must show that the products the company creates generate product market fit in a scalable, growing and highly attractive market.
  2. It must show that all the segments for which the products show product market fit are attackable at reasonable costs, so the cost of growth must be reasonable compared to customer life time value.
  3. It must show, that if you win the markets, you can reap net revenues that contribute to your going concern opex (operating opex)
  4. Your funding mix should be sufficient to cover non-operating OPEX
  5. And of course your capital structure fluff under the EBIT margin should make sense

Good? Good.

That is still very abstract. Let’s discuss a cool operating model template I typically use to show first time founders the tasks at hand.

Operating Model Part 1

That you can see above that you can put a lot of stuff above your net revenue. And that is the key point. You have to understand that in your P&L you have three key areas as a start-up.

The stuff above the net revenue position which we can call Net Income Generating Costs (or NIGC) or Net Revenue REducing Spending (NRRS). We stick to NRRS as in the previous article.

Below the NRRS you have your secondary value chain costs. This can include other operating items such as other operating income (FX gains, revenues from subsidiaries) and other operating costs (FX losses and cost of subsidiaries). But the core goal is to map out your operating OPEX.

And last, your third block is non-recurring items which you can pool with non operating items – since they are essentially not part of your going concern operations. We ignore capital structure and tax issues for now.

So you have three positions:
1. NRRS
2. Operating OPEX
3. Non-Operating OPEX

Next step is to understand the very basic relationships between these three areas.

NRRS are in general non-recoverable costs. Any investment or any dollar spent on NRRS is supposed to generate dollars in revenue. It is really that simple. What you are managing when you are managing a start-up is the elasticity of revenue towards any dollar spent on NRRS. This can be done by spending more wisely, defining segments more clearly, or by having investments into the support functions that hide in the operating OPEX. The higher your revenues tick upwards by the dollar spent on NRRS the better.

Operating OPEX are on the other side going-concern cost items with no direct correlation with revenues. But the interest part here is going concern. First of all, you are likely to spend the same amount of dollars if you spent it last months. So it is a more stable and going concern portion unless you run cost cutting initiatives or you are investing into growth. But the key here is that operating opex is a support for your NRRS. That means, if you have to double your IT spending in the G&A/operating OPEX to triple the elasticity of your NRRS spending on revenue, you should better do that. If your line item in the operating opex has absolutely no correlation with your revenues or your NRRS efficiency, you should treat it as a “minimize cost” item. If you have reason to believe you can improve NRRS efficiency, you may invest into that. So operating opex is composed of a contributing secondary value chain component, and a non-contributing secondary value chain component. If you are eager, you can split these two worlds. But maybe that is a bit of overstretch.

So what is non-operating OPEX? In essence, it is all that non-going concern OPEX that you invest in to improve your operating OPEX efficiency and your operating OPEX capability to drive NRRS efficiency.

That is a crucial point. You could, let’s say, hire a tier 1 marketing consultant to support you on marketing initiatives. If you are planning to fire this guy again somewhere down the line, this could fit into NRRS as cost of growth. But if you are hiring this person to build the marketing capability of our going-concern operating OPEX function called marketing, it is a non-operating OPEX item, or “an initiative” or an investment into the efficiency of your operating opex.

Simple. Right? Now let’s revisit the picture above.

NRRS in detail

Operating Model Part 1

The NRRS is divided into COGS; Cost of Sales, Cost of Retention and Cost of Growth. Why?

Cost of Goods sold correlate, let’s say, 100% with your gross revenue. They are directly associated revenues. In a SaaS world, that could be hosting infrastructure. This can still be managed and lowered by increasing efficiency of your infrastructure operations or product. But in general, that is your COGS. Youl will have a very decent 98% gross margin on a decent SaaS model or more. But that is not a realistic profit margin, is it?

This is why efficiency in SaaS startups is measured in “CAC-to-TLV” ratios. Where CAC is your customer acquisition costs and TLV is total lifetime value of your customer. But CAC is a terrible name and the concept is bogus and heavily manipulated by many start-ups. So I divided CAC into cost of sales and cost of growth. Why?

Well, cost of sales describes the efficiency of your sales process. If your sales process works, you return let’s say 1.50 dollar of revenue for every dollar spend on acquiring this customer. That means you generate 1.50 dollar of net revenue II for every dollar spend on marketing. Now marketing is in cost of growth. If your sales process is efficient, the return on investment for every dollar of marketing should remain your 50 cents. But is that dollar of marketing a dollar of your cost of sales? In that case, you are losing 50 cents for every dollar spent. And that issue can come up for start-ups. But to do exactly this – spend 2 dollars for 1.50 in revenues or CLV can make sense during the market share acquisition game or the “growth” phase. Because you will see attractive CLV growth as your market share becomes large.

That issue with paying 2 dollar for 1.50 here is why typically in CAC you have cost of growth included and the saying goes you need CAC lower than CLV. But if you want to model the product-market fit of your product in a segment with a particular sales process, this is something different from cost of growth. In other words, if you ignore retention for a moment, your product market fit is acquired financially if your cost of sales and cost of goods sold are covered by the revenue on the dollar. If you give yourself a million years, your company will make a lot of money the more sales people you throw into the ring.

But that is not the reality of businesses. You have time pressure and you need to grab markets fast. For this you need to account for cost of growth.

Apart from that philosophical discussion, you want to understand the cost of your sales force and its ability to generate revenue from SQLs (Sales qualified leads). You want to generate SQLs via marketing initiatives and marketing-based qualification (MQLS or marketing qualified leads as a result). These two things operate differently and the going concern of both is different. Sales people leave if they don’t make revenues. Cost of growth goes to a lower level and becomes cost of retention when you reached peak market share. So cost of growth typically spikes in the growth phase of the business and must return revenues without necessarily affecting the ROI on dollars put into cost of sales. So dynamic aspects are different and you have to manage different issues. That is why it is reasonable to split it.

And lastly, typically it is cheaper to retain a customer. If you can expand your TLV from the original bookings (1-3 year contracts) to contracts running for 20 years and you are expanding these contracts, you have better chances of growing. The cost of growing or farming an account are likely lower than the cost of selling a fresh account, too. So overall, it makes sense to split cost of retention from cost of sales and growth. You could still subdivide cost of retention into account growth / customer success and mere support and actual retention. But let’S keep it simple.

Next: The operating OPEX.

Operating Model Part 2

Now in this graphic we see the Other Operating, Operating and Non Operating Items.
In this context, other operating is focused primarily on management of legal entity cross-charges and synnergies for tax savings. Let’s ignore it. But you can easily run a check this way how every dollar spent on any of the subsidiaries or any other or your main company is impacting your NRRS efficiency.
You have the non operating items that we discussed should reflect investments into improving your operating or other operating efficiency.
More importantly – and this is just a simple example derived from the German standard accounting view you would see on a typical start-up – you have similar items compared to the Cost of growth or sales. That is correct. Because you should only put stuff into your NRRS if it really is part of the NRRS. There is always a trade-off between considering things as non-recoverable costs that are blown to get dollars of revenues – or which fail to do exactly that – and going-concern operating OPEX. Why is that?

We will say that your operating OPEX is a recoverable expense! While there de facto exist no single accounting standard that allows you to understand or treat OPEX as an investment into the balance sheet, it is in fact wise to consider every dollar in your P&L that recurs on a monthly basis to become more efficient and creates some form an asset which you can not sell but lose. And that is the philosophy behind looking at operating opex and non operating opex form an OpModel point of view.

But there is of course more to this. Let’s consider you have a very expensive IT system and nobody uses it, this certainly isn’t an asset, but also shouldn’t be a going concern but a “write off”. Maybe it is an experiment that after you finally cut it out of your IT stack moves entirely into your non operating OPEX. Again, we are not talking accounting frameworks here, we are talking operating models.

The same is true for an employee. Elon Musk talked about humans in organizations as vectors. It is absolutely sure that every recurring spending on an FTE will increase this persons efficiency. But it can be very much the case that the vector direction of this person isn’t contributing at all to the company. Maybe this person improves on slacking off and being non-productive and non-value adding. The efficiency will still increase. But it will not translate into the elasticity that OPEX spending has to NRRS efficiency and not impact the elasticity of NRRS spending on gross revenue. So it is bad. But the remedy here is different from the IT system. EIther you replace the FTE and it remains a going concern. Or you cut the position and put it again – in restrospect – into the non operating OPEX area.

Why all this fuss about operating vs non operating opex? Because your business model gets validated when your going concern opex, or your operating opex, is covered by the net revenue generated from your product lines.

Makes sense? Yes. Makes sense. If you cut out non operating OPEX, you are faster in validating your business model. And you are more focused on assessing if something is a net contributor to NRRS efficiency and continues to improve it over time, of if something is a one time experiment and non-permanent spending or an OPEX write-off. (OPEX write offs being the operating OPEX elements that got abandoned and turned into non operating OPEX retrospectively)

Revisiting the op model

So your organization will create products and market those products. The more the better. For every product, you define a segment and build a sales and marketing process around it. Once you get more out of investing into NRRS than you put in, you validate that segment or “product market fit” of the product in a segment.

If you validate enough such products in enough markets, you can generate enough net income to cover your operating OPEX and you validate your business model.

If you didn’t fuck up too much and your cumulative non operating OPEX (historical sum) isn’t too large, you did a great job and will do better next time you run a start-up. (yes, your non operating OPEX becomes your cost of training via Failure)

And if you didn’t bankrupt yourself on the balance sheet and never ran out of cash, you are ready for good investments. The more segments you unlocked using your CLV/NRRS ratios and the bigger the segments, and the less fierce the competition that trains your margins, the more likely you will find funding for growth and create a solid business.

That’s why opmodels matter. This isn’t something I invented, but something I saw many start-ups practice when they want to explain their business models and their customer acquisition costs. And it works if you can explain why you put unpretty and disturbing things out of this view.

At the same time, if you travel, mmarketing and IT maintenance cost are not in the NRRS, your investor has to do more calculations himself or he will be one of those that doesn’t get the game.

Relevance to Exit Valuations

In this context it makes sense to look at valuations. Why? We will see.

Two very dominant early stage valuation metrics are industry benchmarked revenue and revenue growth metrics. High revenue growth and high revenue gives a high valuation. But the current growth rate of the business is of course only one aspect.

It can be observed that companies that attack huge potential markets and have a very low CAC to TLV ratio and a good competitive positioning / value proposition are getting massive valuations and a lot of funds raised. That is only obvious. Because the depletion of those ratios – given diminishing ROI per dollar expansion in CAC or NRRS – will last a while to deplete. But that is only the financial top-down view on the whole thing.

The true magic for this rests in the operating opex. Because this is where the talents in marketing, product management, analytics/data-drive and content creators that craft the sales story reside. They are the ones that drive the efficiency of every dollar spent on cost of growth. The ROI on sales managers hired. If the right target segment is targeted, the right information is provided, you still need the right marketing channel and pay the price, you still need the right sales manager. But the ROI on every minute spent in their day and the ROI on every customer touchpoint will increase with the capability of the operating OPEX.

And that trick goes even deeper. Even with fantastic metrics around your NRRS and stellar revenue growth, if your operating OPEX costs you 10 years of net revenue, you are still not a good investment case. Operating OPEX efficiency is crucial. And it is very easy to kill operating OPEX efficiency by hiring the wrong people, by setting up the wrong processes and support systems, by having the wrong frameworks to work in and having the wrong vectors followed.

Now, knowing all this, understanding the operating model is just the first step to tell yourself the right story and share it effectively with investors. The more difficult part is getting the metrics in a large enough market working. The role of the new CFO is to make the alpha males of management understand operating OPEX contribution to the success of the company. Very likely, those folks come from sales, come from product, from visionaries, marketing. They are taught and cultured to be indifferent to the depths of R&D and G&A / operating OPEX. But not a single hero in any of these areas will run on jet fuel if you haven’t built the engine.

And last, but not least, this unique capability of the operating OPEX will translate into the goodwill portion during the exit. So, in the end, operating OPEX can impact the balance sheet and is a sort of asset.

I hope this was useful.

 

 

 

 

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