There are lots of profitable products and very few profitable companies
Disclaimer: This article is quite a long read. I have made a wrap up in the form of slides. You can download the deck here.
I see a lot of entrepreneurs. Actually, that’s my job to talk to entrepreneurs these days. Quite surprisingly, they all have one thing in common.
They all have a profitable product.
Entrepreneurs are great product people. They excel at making amazing products and delivering disruptive customer experiences. Consequently, they tend to focus on the first stage of profitability: creating a profitable product. What they usually mean by that is: Selling price — Cost Of Goods Sold > 0.
But a profitable product does not make a profitable company.
Turning a product into a company requires distribution and operation resources. As a consequence, I work a lot with talented entrepreneurs to help them understand where they stand on their journey to profitability.
The Path to Profits is a simple framework CEOs and Entrepreneurs can use for quickly identifying their companies’ stage of financial maturity and the levers and options they should consider to turn their products into profitable companies.
1. Profits from product
First, you want to understand how much profit is derived every single time you deliver your value proposition. In other word, for every product you sell, how much profit do you make (not taking into account Sales & Marketing expenses)?
It’s crucial that you reason on a per unit basis. You want to make sure to identify and isolate the variable costs that are required to deliver your product.
1.2. Constituents of profits from product
Here are the most frequent categories of variable costs:
- Human capital: maintenance and support, account set up, account management… For example, if for every sale you make, an account manager has to spend half a day configuring the customer account, this half day should be into your variable costs. On the other hand, the CEO’s compensation is not a variable cost for the product.
- Infrastructures (storage, hosting, computing…). Don’t forget to have it on a per unit basis.
- External services (API, sub-components of your product,…)
- Cost of Goods Sold (COGS)
- Shipping and logistics costs
1.3. Levers for making or optimizing profits from product
Challenge your pricing
Price is what you pay for, value is what you get
— Warren Buffet
Pricing is the most powerful lever for enhanced profitability since it determines Revenues, the utmost top line figure on your Profit and Losses.
There is a good chance you have set your pricing quite randomly or, at best, by relying too much on intuition or benchmarking competitors / substitutions products.
If you want (and you should) work on your pricing, I recommend reading this great article who brilliantly points out the caveats of pricing strategies and gives an actionable methodology for optimizing captured value through pricing.
Work on variables costs
- Can you automatize certain tasks? Computers are generally cheaper than human at doing repeatable tasks
- Can you improve your onboarding process or/and user interface in order to decrease your costs associated with account management?
- Can you simplify the job? i.e. Can you split a task into smaller simple tasks? By decreasing task complexity, it will get easier to outsource part of the job to less qualified workers and drive down costs
- Can you negotiate better terms with your suppliers?
- Can you decrease the complexity of your product by focusing on key features that are core to your value proposition? Make sure you get rid of every none-core features that are increasing complexity and thus driving costs up
In some rare cases, entrepreneurs sustain unprofitable product. Here are the reasons that can justify such a situation:
- Anticipation of decrease in constituents of a variable cost (example: VR companies are anticipating a drastic decrease in hardware)
- Anticipation of a future automatization of your process. In the case of human costs, start by building a product that is delivered by hand to validate your value proposition. It makes no sense economically but should the value proposition appeal to target customer, you will be able to automatize the task and drop its cost to virtually zero
- Anticipation of volume discounts: your product will become profitable when sales increase
Be very careful of such anticipations. For three reasons:
1. you are postponing the empirical answer to the product profitability question
2. you should not underestimate the costs of getting large sales volume and should not overestimate your market size
3. you should not underestimate the investment required to automatize task done by hand
1.4. If you cannot turn profits from product
Startups with non-profitable product are not worth much, unless they have (i) a critical value proposition which their target customers are desperately asking for and (ii) are difficult to copy because they have IP, know-how, secret sauce…
If you are not in that position, your options would then be to get acquired or “acq-hired” by a bigger company in your space.
Otherwise, try pivoting if you still have cash on hands or stop and do something else if you are dry!
2. Profits after distribution
Poor distribution - not product - is the number one cause of failure.
— Peter Thiel
Getting profits after distribution means you are still profitable after you subtract your Customer Acquisition Costs from your product profits.
Your Customer Acquisition Cost or CAC is the amount of Sales and Marketing expenses you have to spend to get a new customer.
Practically speaking, it is often difficult to have a precise and meaningful CAC, since it will evolve over time as you (i) discover and open new acquisition channels (ii) increase your sales efficiency per channel.
Nevertheless, what you do not want to miss is the order of magnitude of your CAC.
Let me explain.
2.2. Constituents of profits after distribution
Depending on your target customer (Fortune 500, SMEs, Consumers,…) and on your price point (less than 10€, more than 100K€ / year,…), you can get an idea of your sales complexity.
- Low sales complexity means touchless sales i.e. no sales people. Customer acquisition is done by marketing channels
- Medium sales complexity means you have sales people selling on the phone and who do not need to visit the customer in person and / or require numerous conversation before closing a deal
- High sales complexity means you have sales people working on the field visiting the customers with usually long sales cycle
- Channel distribution is not covered here as it is rarely used by startups
Obviously, the more complex the sales, the more expensive it is.
Luckily for us, Entrepreneurs and VCs have written about their experiences on the CAC subject and are helping us out to have a broad idea of CAC depending on sales complexity.
2.3. Levers for optimizing profits after distribution
First off, there is a case where not getting profits after distribution is OK: when you are looking for your first 10 customers. In that case, you are still trying to validate your value proposition and you will have to manually acquire these first customers with an unscalable and unprofitable sales model.
When your value proposition is validated and has been sold to more than 10 customers, you are in search for a repeatable and profitable sales model.
If you are in that delicate situation where your CAC is greater than your product profit (or Life-Time Value / LTV), here are the options at your disposals.
Identify new sales channels.
Are you sure the channels you are using to source new customer or lead are efficient enough?
Gabriel Weinberg has identified 19 marketing channels for sourcing leads and customers. Evaluate them with the Bullseye framework by the same author.
Optimize existing sales & marketing channels, a lot.
Some marketing tools, especially paid search and paid social media, are increasingly complex. Marketing teams are generally not experts for each channel and are likely to sub optimize buying strategies, leading to expensive Cost per Clicks or similar indicator.
Do not hesitate to hire a specialized consultant or agency per channel. Set up the accounts with them and learn from them. Let them teach you how to handle a specific channel before you can internalize the expertise.
Structure your sales team
For medium and high complexity sales models, you will have sales persons. Sales person are expensive. The more experienced the sales team, the more expensive it will be.
Sales person often take care of the whole sales process, from identifying leads to chasing them; which is, at best, suboptimal.
Separate your whole sales process in subparts. Structure your sales team around subparts by affecting your most expensive sales people to the more complex parts of the process. Work with less experienced sales people for simpler subparts (identifying leads, cold calling, emailing…).
Decrease Sales complexity
If you have tried all of this above and are still looking for a profitable distribution model, you should consider decreasing your sales complexity.
Perhaps your sales model is not consistent with you target segment or your price point.
Maybe you do not need sales person on the field and you could replace them with inside sales representatives who are fed with qualified leads? Maybe you do not need sales people at all and should have a paid acquisition strategy?
Take a look at this figure which is summarizing the various factors that are increasing/decreasing sales complexity:
Review your pricing
Once again, try reviewing your pricing. Pricing must take distribution costs into account. Distribution is a major component of price.
2.4. If you cannot turn profits after distribution
Challenge your value proposition & target segments
Try reviewing your value proposition:
- Do you need more features and more value in your product?
- On the contrary, do you need to downsize your set of features and simplify your product?
By playing with the value cursor, you will be able to contemplate other target segments which may be better aligned with your current sales model.
Get acquired by a bigger player in your space
If you feel that you have tried everything in your power and still cannot build a profitable distribution model, you can try to get acquired.
Look for a company that already sells to the same market because their marginal CAC for your product is close to zero.
Your product is a way for your potential acquirer (i) to increase its average basket per customer which usually dramatically increase profit and (ii) to increase retention among customers by complementing its current offer with a new service/product.
3. Profits from operations
Eventually, the margin you derive from each sale after variables costs and distribution will have to pay for the investments and overheads.
At this stage, you will no longer reason on a per unit basis. You are looking to cover your fixed costs.
3.2. Constituents of profits from operations
- Compensation for management team and all staff that are not directly involved in production, marketing and sales (HR team, finance team…)
- Offices and office management expenses
- External services not involved in production, marketing and sales, such as accountants, lawyers, consultants, …
Amortization of investment (investment divided by its lifetime)
- Hardware investments
- IT investments
- Brand investments
3.3. Turning and optimizing profits from operations
Increase sales volume
Up to a certain sales volume, your amortizations & overheads will not increase with additional sales. Hence, more sales means getting closer to covering them and breaking even.
But fixed costs are never fixed forever. Bear in mind that amortizations & overheads works in thresholds. Maybe these costs are fixed for serving 1 to 1,000 customers. Maybe they double for the next thousand customers.
- Thresholds can also work at your advantage. See if by increasing volume you can rework your variable costs (see 1.3).
- Try renegotiating your fixed costs (offices, external services,…)
Increase the average contribution per customer.
Since your marginal distribution cost for additional services and offering on your existing customer is close to zero, you can dramatically improve unit customer contribution by cross and up selling to the same customer.
Challenge your pricing, again.
Capturing value is an ever-ending process.
3.4. If you cannot reach profits from operations
Work on all layers again
Because you are at the deepest possible layer of profitability, every action that will increase an upper layer (pricing, variable costs, CAC) will have an impact on breaking even.
Challenge your assumptions
- What sales volume do you need to break even?
- Does it represents a small percentage of your target market?
- Have you overestimated your market size or in other words, does your value proposition only appeals to a subpart of your target market?
- Can you reach your target market share with your current distribution model?
Even if you cannot reach operation profits, you are likely to have created tremendous value on your market by validating value proposition and distribution channels.
The Path to Profits is by no means a unique way of approaching your numbers and KPIs. Do not hesitate to get in touch should you feel like contributing to this framework or if you have questions about it. You can get in touch with me on linkedin here: https://www.linkedin.com/in/matthieulavergne/