This is part of my ongoing series of posts and I need to file this one under both Raising Venture Capital and Startup Advice.

I remember going to an Under the Radar conference in 2006 in the heat of the Web 2.0 craze.  There were tons of young entrepreneurs showing their latest Web 2.0 wares.  Ajax was the new buzzword and many companies went overboard.  People mistook extra doses of Ajax for a successful product.

Unfortunately this was reinforced by the many conferences that rushed to espouse the benefits of Web 2.0 and the subsequent acquisition sprees of companies like Google, Yahoo!, Cisco and others went out to fill out their Web 2.0 portfolios.  Many of these businesses were what First Round Capital called FNACs (features, not companies – this acronym has always stuck with me).

The last 12 months has seen the rise of many new trends.  Facebook Apps, iPhone Apps, Social Games and now The Real-time Web (finally a new, sexier buzzword to replace Web 2.0.  RIP 2.0.  Sorry Tim O’Reilly – you’ll have to work at coining the next trend. )

The last couple of years has also seen the huge initial success of Ycombinator, the Lean Startup and many other product driven approaches to going to market.

Broadly speaking this last trend has been healthy as it has brought an increase focus on launching products that you can test with the market and on capital efficiency.  It has also brought about my favorite new term –Ramen Profitable.  Someone remind me to do a future post on why I think the Ramen Profitable approach has actually hurt some businesses.

In all of these new product and cost-focused new trends, a big problem has emerged that all of these movements have not addressed.  In an era of “launch and learn” is there a need for a business plan?

Short answer: absofuckinglutely. 

I have seen really great product people espouse the death of the business plan.  Do so at your peril.

So, definition: when I talk about a business plan I’m not talking about a 40-page Word document outlining your market approach.  That died with waterfall software development.  I’m not even talking about your 12-page Powerpoint presentation that you need to raise venture capital or to talk with potential biz dev partners.

I’m talking about your financial spreadsheet.  I will quote a prominent, well-known entrepreneur whom I like and respect and who told me when he was raising money, “I don’t know how much I’m going to charge for my product so why should I create an artificial spreadsheet?”

Here’s why: Your financial model tells a story. 

Let’s take your revenue line.  It should talk about how many customers you think you will acquire and how much you’ll charge for your product.  If you can’t estimate the former then I would suggest you haven’t done your homework before building the product.  Do you really want to spent $100k building a product to discover through Customer Development that the market is too small?

Don’t know how much you can charge for your product?  Let’s start with how much value you think you’ll create for your customer if they use your product in terms of hours saved, costs avoided, extra sales, better conversion rates or whatever.  If you have no clue then I would suggest you haven’t thought hard enough about whether there is a real problem you’re solving.  Better that you find that out before showing off your wares at the next trendy conference only to smoke your friends & families’ money.

What about your competition – how much do they charge?  If you plan to charge more than them I need to know how your product will differentiate to command a premium.  Going to charge less?  How will you go to market in a cost effective way to achieve similar margins as your competitors.

See I don’t care if your projections prove wrong over time.  I care about your assumptions going in.  I care about the thought that you’ve given to the customer problem.  I care about how much you’ve thought about market share, competitors, adoption rates, etc.

My suggestion is that you do a detailed MONTHLY plan for the first 24 months and then an annual plan for what we call the “out years,” 3,4 and 5.  Why do VC’s care about these years?  Good ones don’t care about the granular details in a startup but they do care about how big the market is, what share you’ll get and what assumptions you make about pricing over time and other market factors.  VCs care that you’ve thought about these issues.

The cost side of the equation is also important.  The COGS (costs of goods sold) tells me about how big your customer acquisition costs will be.  I should be able to test these assumptions against comparable companies.  If you’re a consumer destination the revenue and COGS lines should tell me about how big your funnel is, how you fill the top end of the pipe and what your conversion rates will be.  Ditto for enterprise software companies.

Don’t know what LTV is? It’s “lifetime value” of a customer.  If you don’t understand why this is important I encourage you to do a little Google research.  Not knowing can be the kiss of death in raising money but more frankly the kiss of death in your business.  Great product managers who are not great business people still often fail.

What assumptions do you make in the cost lines about people?  Usually in a tech / software startup 70-80% of your costs will be people.  This is where I spend most of my time.  How many people will you hire in the first 24 months and in which sequence.  How much will you pay?  Don’t know the running rate for engineers?  Fail.  This information isn’t hard to find.

How will your costs scale as your revenue scales.  We see many naive entrepreneurs who tell us, “My revenue will grow to $60 million by year 5 but my costs mostly stay flat.  I won’t need to hire many engineers or customer support staff.  This stuff is ‘zero gravity.’  Our Net Income will be $40 million.”

Really?  66% Net Operating Margins?  Show me companies doing this.  I don’t think my job is to teach you economics or financial modeling.  And frankly I’m somewhat forgiving of people who are naive about the “out years” like I outline in the last paragraph.  But many investors are not so forgiving.  Do your financial model and run it by friends or colleagues for feedback.

Financial Models are Not Just for Fundraising

Finally, one last point about financial models.  They are not just for fund raising.  They are the most important document you can prepare to align your management team on where you THINK your business will go.  They are your map.  If you’re flying from SF to NY with no map I can assure you that you won’t get there.

Each quarter you should review your model.  What assumptions proved wrong in the last quarter.  How does that change your assumptions going forward?  Too aggressive about the rate of customer adoption?  Better to model that now.  You might then slow down your burn rate or raise more money.  Your funnel wasn’t wide enough?  Do you need to rethink referral deals or do you need to improve your conversation rates to hit the same revenue numbers.  Or do you need to raise prices?  Or lower revenue assumptions.

You get the point.  Financial models are the Lingua Franca of investors.  But they should also be the map and the Lingua Franca of your management discussions.