You don’t have to be an experienced CFO to understand and improve your company’s economic performance. In fact, with this high-level guide you can dive right in by learning how to discover, develop, and optimize your economic model.
When most software companies are founded, they follow a similar developmental path.
First, company founders work hard to build a solution with a great product-market fit. Next, as the business gains traction, its team begins to focus on growing the company’s user and customer base. Finally (and often concurrent with the previous step), the business continually pushes its people to establish a clear competitive advantage in its market.
But as most entrepreneurs know, there’s much more to building a great, big software company than those three things.
In fact, the best companies are able to complete each of the steps above while also developing, deploying, and monitoring another critical component of their business: their economic model.
What is an Economic Model?
An economic model is simply a tool designed to isolate and analyze the core drivers of financial performance in your business. It should weed out excess variables and enable you to focus on the revenue generated by each of your customers, and estimate how that relates to — and can be impacted by — investments in marketing, product development, or administration.
It is important to understand that an economic model is not a business plan or a business model, nor is it the basis for a budgetary or forecasting framework. Instead, it should serve as a lens that allows you more closely examine your business model and make adjustments that:
- Drive growth without consuming a lot of capital
- Develop stronger economic results and gross profit over time
- Communicate to others (i.e. investors) that the business you’re developing will deliver strong economic results far into the future
The ultimate goal of an economic model is to determine whether or not there are gaps or inefficiencies between the company’s targets and its data, which requires establishing some benchmarks to judge the results by.
Boost Your Growth Rate by 25% by Discovering and Optimizing Your Economic Model
As incredible as this might sound, I believe every company can increase its economic model results and its growth rate by 25 percent if it begins to focus more on developing its economic model.
That being said, that can’t happen unless you first invest time into discovering exactly what your optimal economic performance should be. You can do that by executing four fairly basic steps:
- Uncover your current economic model: How are you delivering value to current customers? What is an average customer worth to you and how much did they cost to acquire? What else do you spend money on and how will those costs scale as you grow? There are numerous components to an economic model and the ones that matter most to your business are likely unique.
- Hypothesize a better future: Where will your company go if it sticks with its current model? Could you grow faster and bigger by spending more on specific areas of your business? How much different would your future look if you accepted outside financing? The more you study, play with, and understand how your economic model works and how you can improve it, the more you will have an intuitive understanding of what you need to do with your business.
- Identify actionable opportunities to improve: What initiatives could you execute to lower your cost of customer acquisition? Is it possible to incentivize customers to pay in advance so that you can avoid having to accept outside capital? Your goal here is to create a comprehensive list of ideas that could make your existing economic model better.
- Experiment and iterate: Prioritize the ideas you come up with to develop a list of your best opportunities and experiment with them. As you go, expand on best ideas and kill the rest.
It’s important to remember that this will be an iterative process. Once you’ve completed the steps above, you should periodically revisit your economic model by going back to step one, and repeating the process again to adjust your model to your current reality.
5 Characteristics of Attractive Economic Models
If you have actually begun to dive into your economic model, you might be wondering how to determine if your model is actually an attractive one.
- Your cost of acquiring new customers is low relative to the cash flow that they generate once they become customers.
- Your existing customers deliver high gross profits/margin.
- Your customer retention is high and you’re able to increase their business with you over time.
- You can get away with a small amount of R&D for your existing customer segments and still maintain or grow your competitive advantage to current customer segments.
- Your target market is large enough to fuel growth in your current customer segments for a long period of time (the longer, the better).
Simply put, the most attractive economic models have low cost of customer acquisition, high gross margins, and customers who stay with the business — and commit more to it — over time. If you have all of these characteristics, your economic model is in good shape.
Now or Later? Deciding When to Optimize Your Economic Model
While there are some obvious benefits to developing (or improving) your economic model now, there are some risks to adjusting it, as well.
For instance, here are two legitimate reasons for waiting to make changes to your existing model:
- You don’t want to distract your product development team from building product features that will drive initial user engagement and customer acquisition.
- By having some uncertainty around your economic model, your business might actually be more valuable to investors or potential acquirers, and more dangerous to competitors. That is, the mystery around what your economic model is (and could be) could cause investors to dream big and competitors to scratch their heads.
That being said, there are risks associated with not optimizing your economic model. For example:
- By not understanding which components of your product are most profitable, you might be wasting time and resources on the wrong things.
- If you don’t explore the economic viability of your current model right now, then you don’t give yourself the opportunity to fail fast and move onto something else. As a result, you may invest time and money into something that will never really be profitable.
The bottom line is that you must spend time exploring your economic model and evaluate that benefits and risks of making changes to it.
There are some successful companies that have been built by worrying about acquiring users first and the economic model second (Google comes to mind), but there are also a large number of companies that have failed by taking that approach.
Are You Blind to Your Economic Model?
While some founders may say they understand the need to develop and manage economic model performance as part of their comprehensive management system, many management team members (including financial managers) fail to truly optimize and capitalize on their economic results.
There are several reasons for this:
- Over-emphasis on users: This is a bigger problem in consumer industries, but far too many businesses become obsessed with user growth when they should be worrying about how to actually make money.
- Singular focus on gross margins and revenue growth: Yes, these financial metrics are fundamental, but they’re just part of a truly comprehensive economic model.
- Numbers aren’t fun to pore over: Most entrepreneurs are busy trying to build their product, team, and customer base, and don’t believe they have the time (or expertise) required to develop and deploy an economic model.
- Financial skills are lacking: Financial people are generally good at satisfying accounting and regulatory requirements, and providing GAAP financial results. But GAAP financial results are very different than economic models and most financial people have not been been trained in business economic modeling.
- Lack of good operating metrics: Economic models need good operating metrics to be truly clear. Making matters worse, it takes a lot of work to gather and clean operating metrics so that they can be used in modeling, and many entrepreneurs argue that they don’t have the time to do that.
While developing an economic model might seem daunting, the truth is that every company has an optimal economic model that is waiting to be discovered. It’s simply up to you to set up a management approach that will allow you to go down the path of discovery.
By analyzing your economic model you can determine the drivers impacting your performance and then move to improving productivity.
- Economic Model Series: Summary of Posts OpenView Blog
- Economic Models: Simulations of Reality by the International Monetary Fund
- Eight Realities of Startup Economics by David Capece, Wharton Magazine
- Does the SaaS Sales and Marketing Economic Model Work? by Tien Anh Nguyen
Are there any points you would add to this guide?
Photo by: NASA’s Marshall Space Flight Center