Lean Startup Economics
Creating a startup is best done by jumping in with both feet. Building a minimal product and finding customers early in the process is a great way to create a company from scratch. The idea of WRITING A BUSINESS PLAN is such a daunting task that most reasonable people aren’t going to go tackle it head on.
But there is an alternative, take it out one piece at a time. The central piece of the business plan is the financial model. The central piece of the financial model is the unit model: a fancy term for the expenses and revenues associated with producing and selling a single item.
Here are four steps for building a unit economics model in parallel with starting the business. This makes the model a living document rather than a dusty academic exercise. So, here are the four steps:
- Step 1: ?
- Step 2: Make $1
- Step 3: Make $2
- Step 4: Make $1,000,000
Fortunately, these steps are inherently in order of decreasing difficulty. I’ll get to step 1 last.
Step 2: Make $1
Make a product. Go sell it. Don't wait till it is perfect. It won't get perfect until you've tried to sell it, so that's a waste of time anyway! It’s a long journey from the idea to the first $1. This involves solving a real problem well enough that somebody will pay for it. As soon as you sell something, you've got customers. And once you've got customers, you have the most valuable data available about how to make your product better.
Try to quantify how much it costs to make that product, market it, and close the sale. The dominant factor in building and selling this first product is the founder’s time. So, to build a reasonable model, put a dollar amount on that time. Not only is it the dominant factor, founder’s time is also the scarcest resource. The business only gets 90 hours of it every week, and can’t manufacture more. Now you’ve got a unit model!
Step 3: Make $2
There is a catch here. This second dollar comes from a repeat customer. To get a customer to repeat, the product you sell needs to be of such high value that they couldn’t go without it. The odds of hitting this mark on your first product are very low. Refinement over time to improves a product to this level, rather than a single shot in the dark.
Now, update your unit model. Instead of having revenue for a sale of a product, include the lifetime value of a single customer. Include all of the incremental cost to provide that product a 2nd time. Also, figure out how much it cost to get that customer to repeat purchase. Here is a hint, it should be about 10% of the original cost.
A word of caution at this point: If you don’t have the possibility of repeat customers in your business, just stop right now, the business isn’t very good.
Step 4: Make $1,000,000
Now that you’ve got customers and a product that they can’t live without, figure out how to sell many customers and produce many products and collect lots of dollars. At some point around this time frame get a business license. This becomes an operations and scaling issue, and there are great people who love doing this who can help grow the business. Don’t try to do it yourself.
For the financial model, this means understanding headcount numbers and benefits, attrition rates for customers, conversion rates on the product, etc, etc. The best way to figure out how to build a financial model is to look for investment. They will tear up your crappy documents again and again. Think of this as free consulting.
Step 1: Quit your job
All those other steps are at worst an academic exercise and at best a hobby until you quit your job. A lot of stuff has been written about making great entrepreneurs, but one element that comes up repeatedly is hunger. I take this literally, not metaphorically. Make the sale, or eat ramen noodles. Great motivational stuff, ramen noodles.
This makes the financial model real too. Don’t think of the hourly rate for the founder’s time as a theoretical concept. Actually pay it. This also puts a time limit on everything. The business bank account and the personal bank account are in a race to hit zero. The only thing that helps either one is sales.
This post in video
Here is a video of me giving a talk on this same subject to Chicago's Lean Startup Circle
This post in alternate video
This is also a pretty close approximation of the talk too. But a lot funnier. Big Props to Edward Domain of flyovergeeks for pointing this out in his post