Three important issues for start-ups/small businesses to consider
There are many issues to consider when setting up a start-up/small business that can help create solid foundations for the future. In this article we will look at three important factors which are yield management, burn rate and product requirement documents. While commonplace in different sectors they offer a great insight into maximising income, minimising outgoings and targeting your product/service specific demographic.
What is yield management?
Yield management plays a huge role in the hospitality/hotel sector although many of the associated factors can be utilised by other businesses. Initially this concept was created for the airline industry in the 1980s. This allowed companies to be flexible with regards to pricing to maximise income. The key to yield management is dynamic pricing……
What is dynamic pricing?
The best way to describe dynamic pricing is to give you an example of how hotels look to maximise their income by adjusting prices. The concept revolves around the yield formula:-
Revenue Achieved/Maximum Potential Revenue
If we look at a relatively small hotel with 50 rooms with a rack rate of $300 per night, this equates to maximum potential revenue of:-
50 x $300 = $15,000
On a relatively quiet day the hotel is only able to rent out 15 rooms at a reduced price of $250:-
15 x $250 = $3750
This represents a yield of:-
($3750/$15,000) x 100 = 25%
However, what if the hotel was to reduce the price even further down to $200 and rent out 25 rooms that night. This would create income of:-
25 x $200 = $5000
Which represents yield of:-
($5000/$15,000) x 100 = 33.33%
If we look at the hotel industry, the staff required to service all 50 rooms would be in place so there are no additional costs no matter how many rooms are rented out. Therefore it is better to reduce the price, increase income and enhance the yield. Then there are the benefits of add-on sales such as food, drink, etc.
Know your market
While the example above shows how to maximise income by reducing the price of a hotel room, in this industry there is also potential to increase the price. Let’s assume that there is a very popular music concert nearby and all hotels in the area are fully booked that night. In theory many of those attending the concert will require accommodation due to the often late time these events finish. Therefore, there is scope to potentially increase the room rack rate from $300 to $350 in the knowledge there is extremely strong demand.
In this scenario the calculation would be:-
50 x $350 = $17,500
This represents a yield of:-
($17,500/$15,000) x 100 = 116.66%
As you will see the yield for that evening is actually above the standard rack rate and therefore more than 100%. Other factors which may impact dynamic pricing include competition in the area, weather, seasonal demand, and in the current environment, the coronavirus. The key to maximising your yield is to find the maximum price that customers will pay in a particular environment. There are numerous software packages available which will compare and contrast seasonal patterns, how price/demand reacts to local events and work out a dynamic price to maximise your income. These packages are worth their weight in gold.
While we have mentioned the hotel industry and the airline sector, this calculation is relevant for the retail sector and many other types of business. The concept is the same, finding a trigger price which will attract customers and maximise your sales.
Calculating and controlling burn rate
The term burn rate concerns many people but, as with debt, it is something which should be respected but also embraced. If we look at some of the best performing tech companies in the world they had huge cash burn in the early days. The majority of them succeeded because they had sufficient cash to fund the business until it turned cash flow positive. After that, they were able to build on their initial success and hey presto we have some of the most influential companies in the world today.
What is the definition of burn rate?
The burn rate is simple:-
Total revenues each month – Expenditure each month
For example, if you had revenues of $1 million a month and expenses of $1.5 million per month then the calculation would be:-
$1 million - $1.5 million = - $500,000
In this example there is a net cash burn of $500,000 per month. You will also hear the term “gross burn rate” which is in effect your expenditure before adding back revenues. It is a little unfair to quote the gross burn rate if the business is creating income. However, it can give you an idea of variations in monthly expenditure and allow you to plan ahead for the future.
Everything is relative in the world of business. If you have a relatively high gross burn rate but your monthly income is greater, then you are still cash flow positive. So, when considering burn rates and what these indicate for a business, you need to look at both sides of the equation. You also need a comprehensive business plan.
Funding your net burn rate
When setting up a business you can probably write off the first six months or so with minimal or no income. Therefore, if it costs you $500,000 a month to run the business you would need $3 million to cover the first six months. The majority of entrepreneurs will plan ahead for at least the first 12 months taking into account any forecast income towards the end of the period, and how this may impact the net burn rate.
Let us take the extreme situation, in which you have a business that will earn no income for 12 months, after which the income tap will be turned on. So if you have a net burn rate of $500,000 a month then you would need at least $6 million to see you through the first 12 months. In reality you would probably need more money because no plans ever work perfectly and you may have additional expenditure, or your income may not hit the expected targets until month 14 or 15. It is those businesses which leave themselves little in the way of leeway which often struggle. As the funding gets tighter and tighter, potential lenders will step back and only those with an appetite for risk are likely to step forward.
If you were looking to lend money to fund a high risk tech start-up, that was running out of cash and had limited options, common business sense suggests you would charge a relatively high interest rate. Therefore, the best thing to do is work out your expected net burn rate per month and extrapolate this for the first 12 months. Then give yourself some headroom, say up to 6 months additional funding, which allows for any unforeseen circumstances which may delay your income streams. This will keep the wolf from the door for a little longer.
Be wary, be cautious but don’t be afraid of the net burn rate. If you start a business it is unlikely to be an overnight success. The key is finding that balance between the burn rate, affordable expenditure and the creation of long-term income streams – it isn’t easy.
Have you created a product requirements document?
When creating a new product or service it is essential that all members of the team are aware of the long-term goals. The creation of a product requirements document may sound like “yet more paperwork” but this is an essential part of any product/service development. The main essence of a product requirements document includes:-
What is the ultimate aim of the product, are there any existing products you need to target or will you need to educate consumers/businesses on a brand-new concept?
The concept of “know your client”, otherwise referred to as KYC, is very important. Unless you have a particular demographic/business sector in mind, you will probably end up with a range of marketing campaigns best described as “scattergun”. Focus, focus, focus especially in the early days.
How should the product be used
It is great bringing out the best product/service in the world but unless people are aware what it does and how to use it, then it may fall flat. We know from research that consumers/businesses tend to have a very short attention span. Without being rude, “KISS” a.k.a. Keep It Simple Stupid.
Ensure all stakeholders have a say
When creating a product requirements document there is a tendency for a relatively small clique of individuals to take control – in some cases, one person. However, with many different stakeholders involved it is very important to take advantage of their thoughts, their experience and their advice. Even the most successful entrepreneurs in the world can develop “tunnel vision”, which leaves them closed to any external input about their product/service. It is their baby and they will do it their way!
In the words of one of the world’s greatest entrepreneurs, Steve Jobs:-
“It doesn't make sense to hire smart people and tell them what to do; we hire smart people so they can tell us what to do.”
It is also very important to share the success of any new product/service right across the stakeholders, especially those involved from day one. This can encourage entrepreneurship, “thinking outside the box” and make employees feel as though they are appreciated. As a consequence, they will become an integral part of your business and likely much more productive.
At first glance you may feel as though some of the issues raised above are not relevant for your business. However, when you begin to dig a little deeper many of the skills, experience and guidance notes are transferable. The yield management calculation can be adapted for any business, ensuring that everybody is sing from the same hymn book about a new product/service is key to success and then we have good old-fashioned finance. There is nothing wrong with a healthy net burn rate as long as this leads to a healthy monthly income before your funds run out.
Remember to ensure there is more than enough financial headroom in the event that your plans change over the period, as many will. There is every chance that you will need to be flexible about your original idea. Remember Amazon, the company started as an online book retailer and look where it is now.