The first step in building out a financial model is to forecast revenue. As you build your revenue projection, think through the following:
- What is a reasonable price point for my products and services? How can I verify this?
- How many new sales can I get each month, based on my total addressable market (TAM)?
- Could alternative revenue structures work for my business? For example, affiliate commissions, advertising, sale of user-generated data, freemium with upgrades, etc.?
- What is the single biggest customer relationship I could land? Could they help to verify my idea early on?
- What partnerships could I leverage to get greater adoption?
Selecting a Product Type: Subscriptions vs. Unit Sales
Add your Products/Services to forecast Revenue as either Subscriptions (recurring revenue from each sale) or Unit Sales (not recurring).
Unit Sales: every sale is a one-time purchase.
Subscription: every sale is the start of a recurring contract. Only forecast the new signups. The model calculates the recurring ones based on the attrition (churn).
Name your Product/Service
Name your Product or Service effortlessly. You can always rename it later.
Create a separate “Product/Service” for each of your revenue streams. You can use the automatic forecast or paste the number of sales from a spreadsheet.
Unit Sales Product
Unit Sales revenue forecasts the number of units to be sold in each month at a given price
This price is multiplied by the number of sales to get revenue.
For a subscription, enter the effective monthly price, even if you bill quarterly or annually. For example, if your subscription is $240 per year, enter $20 here as the Monthly Price.
Why do we ask for the MONTHLY price?
Even if your subscription is billed quarterly or annually, revenue is recognized in the month the service is provided. In a $240 annual subscription, $20 of value is provided every month, so $20 of revenue should be recognized each month instead of $240 in the first month. Since the cash is collected up front, this also requires a “Deferred Revenue” liability to be created on the balance sheet. “Deferred Revenue” represents the cash collected that has not yet been earned as revenue.
What if I don’t have a fixed price?
For certain pricing structures, you will need to set up the products/services a bit differently. Here are some examples:
- Pricing based on project size – Let’s say your pricing for a project is based on the number of square feet. You don’t know exactly how many square feet each future project will have, so we recommend forecasting based on the average size project. You can also create two or more revenue items to forecast “small projects” and “large projects” separately.
- Fixed plus variable – Let’s say your pricing for a project is $1,000 plus $100 per hour. In this case, create two offerings, one priced $1,000 and the other $100. In the first one, forecast the number of projects, and in the second forecast the number of hours spent on those projects.
Annual Price Increase
Enter the increase in price to be applied at the beginning of each calendar year. Most businesses will increase their prices over a 5-year period, but you can always set this to 0 for a simpler forecast.
- Price = $100
- Annual Price Increase = 10%
- 1st year price = $100; 2nd year price = $110; 3rd year price = $121; etc.
This is the frequency at which a subscription is 1) Renewed and 2) Billed.
First, this affects the renewal. Assume the renewal rate is 90%.
- If the Subscription Length is “Month-to-Month”, then the subscription will be up for renewal every month. Only 90% of the subscribers last month will carry over to this month. One year later, only 28 of 100 original subscribers would be left.
- If the Subscription Length is annual and the renewal rate is 90%, those subscribers will continue throughout the course of the year and 10% will drop off at the end of the year.
Second, this determines the billing frequency. For an annual subscription, the customers can be billed either monthly, quarterly, or annually. For purposes of this model, the customers are billed at the beginning of the period, but you can adjust the “Cash Collection” to determine how quickly they pay.
Renewal Rate (%)
This is the rate at which a subscription is renewed. 90% means at the time of renewal, 90% of customers will renew.
The model uses this to calculate the number of returning subscribers each month, so you only have to forecast the number of new sales, not total sales.
You can edit the “Subscription Length” to determine whether subscriptions renew monthly or annually.
Select the timing of when cash for a sale is collected.
This does not affect the amount of revenue because revenue is recognized in the month it is earned, not when the cash is collected.
However, it does affect “Accounts Receivable” and “Cash”. The timing of when cash is collected can have a substantial impact on a business’ ability to grow.
As an extreme example, Amazon.com has a powerful business model because it can collect cash from a sale up front, and pay its suppliers and distributors weeks or months later. This means more cash is available to invest in growth.
If Amazon had to purchase the labor and materials to serve their customers before getting paid, their Net Income would look the same, but the amount of cash on hand would decrease dramatically. They would likely have to raise money in order to grow.
Select how you want to forecast sales.
For unit sales, this is the number of units sold each month. This is multiplied by the Price to calculate revenue for that month.
For subscriptions, this is the number of NEW subscriptions sold each month. The model automatically projects the number of recurring subscriptions and multiplies that by the Monthly Price to calculate revenue for that month.
You can forecast sales in 4 ways.
- Monthly Detail: paste in your own forecast from a spreadsheet into the 12 x 5 grid. This is most useful when your business experiences a few intermittent sales or a seasonal growth pattern.
- Exponential Growth: enter the number of sales at the beginning and end of the model, and the model will calculate the numbers in between. You can also adjust when you will start and stop selling this particular product.
- Straight-line Growth: same as exponential growth, but the number of sales grows the same amount each month.
- Link to Parent: connect this forecast to the forecast of another Product/Service. You can adjust what percent is carried over, and even add a time period between one sale and the other. This is often used for a software app where users get a free or basic version one month and then a certain percentage will upgrade a month later. Another common example is when customers purchase a hardware product (unit sales) and start the software subscription (subscription) at the same time.
Why does my revenue look too high (subscription)?
If you are modeling a subscription, the app automatically calculates the number of returning subscribers from previous months and adds that to the number of new subscribers this month. Check that you are only modeling NEW subscriptions, not TOTAL subscriptions.
Why does my revenue look too low (subscription billed annually)?
If I charge a user $120 for an annual subscription in January, you might expect to see $120 in revenue in January. However, accrual accounting rules require that revenue is recognized in the month when it is earned, not necessarily when the cash is collected. The model will recognize $120 of cash in January but only show $10 of revenue per month for the 12 months of the subscription. The rest of the revenue is “deferred” as a liability until it is earned.
Other Tips for Forecasting Revenue
- Don’t get caught up in “false precision”. Reality will never match your forecast, so instead of worrying about the details of exactly how many customers will sign up each month, focus on the overall story. Can your business generate enough revenue quickly enough to be exciting to stakeholders at a price point customers are happy with?
- There may be a year or more of building your startup before it can generate revenue. While you are building a scalable solution, you may be able to generate revenue in non-scalable ways. For example, if you are building a wedding planning app, offer wedding planning services. This helps you learn about the market, connect with customers, develop processes and products that you can automate, generate revenue to help cover expenses, and show investors that you can create real revenue.
- Your revenue projection will depend on the business model. However, early-stage investment firms like to see business models with the potential to generate at least $25m in the first five years. If your business will be much smaller, you may need to consider other sources of capital.