When you start evaluating all of your decisions around a return on investment in your startup, you … [+]
No matter how many customers a small business has, if it’s not making a profit, it’s a failing business. The business of building startups, on the other hand, doesn’t always prioritize profitability. In fact, many startups get acquired or go public years later without having ever made a profit. This grow-big approach is not viable for self-funded startups unless they’re making enough money they can use to continuously fuel growth.
Regardless of how you choose to build your venture, generating a positive return on investment in your startup is the guiding metric for every business. From experience researching, interviewing and working with hundreds of entrepreneurs, I found that founders who don’t take the time since the beginning to analyze how and when they will be able to return their initial investment and make money even if it is years later, quit the moment they face a significant hurdle even if it is just weeks after taking their product to market.
Calculating and understanding your key metrics shows you what it will take financially to turn your idea into a profitable startup. Your investment allows you to plan your execution and the next stages around your resources. For instance, if you realize your funds will only allow you to launch a product and run the startup for one year under conservative assumptions such as not generating any revenue, you know you need to start fundraising as soon you go to market.
Over the years, I found that most self-funded entrepreneurs focus on putting together just the required funds to take the product to market. Once it’s live, they’re cash strapped. There is a reason most funding rounds are expected to last startups 12 to 18 months or longer. My advice for bootstrapped founders is to allocate enough cash to launch a product and operate the startup for at least 12 months plus 50%.
This 50% is what I call a pivot fund. Since most startups end up changing their business model or product in one way or another, the pivot fund should be used for unexpected changes in direction. If Groupon didn’t pivot from a fundraising site to its current business model, it wouldn’t have become one of the fastest startups to have ever reached a billion dollar valuation.
Focusing on your startup ROI forces you to build products that are more likely to generate a positive ROI. If you find it impossible to bootstrap your startup, your ROI could be building a fundable startup. In other words, launching a product that people use and that attracts investors. In this case, the question you need to answer is: what will it take to de-risk my startup and prove its potential?
Every milestone, department and initiative, big or small, should start by defining the expected return and the investment required to achieve this return. For instance, as simple as interviewing potential users should begin with an end goal in mind like clearly defining the ideal buyer and how your investment in time and money will help you accomplish this goal and by when.
When you start evaluating all of your decisions around an ROI, you unintentionally start eliminating the decisions, steps and ideas that will not take you where you need to go. And you don’t need to be a finance expert to do this.
Start by defining your ideal expected return and then figure out the investment required to reach it. If your investment is insufficient, break down the return into smaller achievable milestones. At the end of the day, your realized return should be higher than the investment for the milestone even if it takes time to reach the results, as long as the output is eventually higher than the input. And if it’s not, this is where your pivot fund contributes to future investment, which should have a higher probability of success as you will be making decisions based on data from a failed investment.
When you set your expected return for each investment, consider dividing it into three mini-goals: expected return, good return, and exceptional return. Your expected return is what your analysis shows you could accomplish with high certainty. For instance, chances are, if you invest in a prototype and show it to enough people, you will be able to uncover key insights about their needs and expectations.
With a prototype, you may also be able to pre-sell your product and generate enough revenue to fund the next product development stage. This is an example of a good return. And finally, with the same investment, you might also be able to raise the first funding round if this is what you consider an exceptional return.
This approach allows you to focus on capturing the simplest and most realistic return on investment. It also pushes you to try to realize higher returns with the same investment until you learn you need to make further investments to achieve those higher returns.
In conclusion, know your numbers. Even though startups at the idea stage can be unpredictable, remember that progress is the sum of small steps forward. When you focus on a few steps at a time, you can confidently measure your progress and the required investment.