REVENUE EQUATIONS | The Litmus Test of a Company’s Revenue Model

By Anne Marie Maduri ● January 08, 2015 03:35



When analyzing a business model, my first question is: “What is your revenue equation?” This usually triggers a sizzle of annoyance from the entrepreneur whom I’ve clearly disrupted from launching into a scripted pitch of their business.

Once it is apparent how a company generates (or intends to generate) revenue, as elliptically captured in the revenue equation, a potential investor or I can begin to assess the viability of the full business model. (This summary statement of the income side of the business model, or the ‘revenue model’ is subsequently complemented with the cost structure.)

In developing revenue equations, I follow a relatively straightforward process:

1.  Rule:  It must easily be reduced to “First Principles”:

Revenue = Price x Quantity

“Easily” implies that the structure “P x Q” must be transparent, despite the possible complexity of the components.

2. Outline the drivers or assumptions behind the Price:

  • Market Dynamics and Potential
    • Is your product or service opening up a new market (i.e. is it market leader)?
    • Is it entering a competitive market in a novel or unique way? If so, how is it differentiated from the competitors’ offerings? And, where is it positioned in the market spectrum relative to competitors?
      • How are these factors reflected in the price?
    • Are you targeting multiple categories of customers?
    • How will customers respond to your price?

3. Specify the assumptions made to determine Quantity:

  • Triangulate from various approaches
    • Derive from the top down: find (credible) industry estimates of what the market will bear and target a growing portion of it.
    • Derive from the bottom up: estimate what your company can produce or deliver, and grow the amount accordingly over time.
    • Iteratively “guestimate” from both perspectives, and then compare against the typical sales cycle (btw, how long is that?).

4. Market Validation of P and Q.

  • What is the feedback from Proof of Concept customers? Existing customers? Prospective customer meetings?

    • Adjust either or both accordingly.
    • How do these compare to industry benchmarks or market data?


Example

The following is a single Free to Play (F2P) game’s revenue equation designed to show revenue on a monthly basis:

A revenue equation should be rich enough to capture the key metrics or factors of your business. Regardless of how apparently complex, the equation should be readily understood once parsed and reduced to first principles.

The sophistication of the equation increases over time as you hone the business; and the quality of the estimates improve as you tweak and iterate so that the output reflects the business’ “reality”. This process should be used to develop each revenue line that comprises a company’s revenue model. A spreadsheet is the best tool for this exercise.


Anne Marie Maduri is a finance specialist and ideaBOOST mentor. Maduri & Associates provides investment banking and advisory services to companies in the Digital Media Entertainment and related technology sectors. 

In her next article, Anne Marie will review the macro-economic climate for digital media, entertainment and related technology investments. If you missed her previous article, see Building Sustainable Companies that Attract Investment.


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