Business validation through numbers (Part 2)

In this part we will mainly focus on:

• market share
• investment evaluation such as NPV and IRR
• sensitivity test

# What market share are you gonna take and at what rate

In order to be the most realistic, a market share of your business should start at a reasonable rate. Be careful not to overestimate sales.

Keep in mind that it takes time to get into the market and build a brand until you get a sufficient amount of customers to your customer base. Thus, the market share should not be a linear function. It should start at a lower rate and gradually grow into higher rates.

Depending on how big the market is and what your goals are, the chunk of the market that you want to take should stop growing at some point in time. Pick a period in which you want to acquire the biggest part of your customer base and finish the growth at that point.

# Expenses

Expenses differ from business to business. One country might have different development costs or different wage rates than the other. Here are some variables to consider:

● typical CEO salary

● how many employees do you need to cover all the operation

● minimum wage to satisfy your employees

● if your business is technological how much money do you need to develop the project

● what is the typical cost of rent in your area

It is important to take each of the aforementioned variables into account. As I have mentioned in the introduction, it is crucial to stay as unbiased as possible especially in this part of your analysis.

# Basic investment evaluations

Several financial metrics will help you to justify the final decision. My favourite is the net present value (NPV) and closely linked to NPV, internal rate of return (IRR). In this section, we will describe what each one means and how to calculate them.

# NPV

Net present value or NPV for short is a financial metric that shows the opportunity cost of future cash flows given a certain period and discount rate. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or a project. In the formula below the discount rate stands for the opportunity cost. In other words, 100 dollars today are not the same 100 dollars in the future due to inflation rate for example.

The following formula is used to calculate NPV:

where:

Rt = Net cash inflow-outflows in a single period t

i = Discount rate or return that could be earned in alternative investments

t = Number of time periods

The first step in calculating NPV is to set variables.

● What is the number of periods we will look at?

Try to identify.

● What is the opportunity cost (discount rate)?

In the picture below you can see how NPV can be calculated in a spreadsheet. Be careful to put the power of t in each period. Also do not forget to put the initial cost of the project (if there is any) but notice that the initial cost is not discounted.

# IRR

The internal rate of return (IRR) similarly to NPV is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return tells us what is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. In other words, what is the maximum growth rate of a project that we can expect? Hence, projects with higher IRR will be more desirable for you and your company.

To calculate IRR we will have to rely on the same formula as for NPV. There is no analytical formula for calculating IRR so we will have to use an old practice of trial-and-error.

The first step is to set a discount rate in the NPV formula so that the result is close to zero. In the screenshot from the spreadsheet below, you can see that I set the discount rate to 10% which gives me NPV=€2300. That is close enough to zero, now I need a discount rate that will give me a negative number as a result. In the picture below that rate is 11% which gives me NPV=€-150.

Now I have all the variables that I need to find IRR of the project. The final result should be something between 10% to 11% so you will instantly know if you have made a mistake (if so, the number is above or below these rates). To find the exact IRR use the formula below:

where:

ra= lower discount rate chosen

rb=higher discount rate chosen

NPVa=NPV @ ra

NPVb=NPV @ rb

This measure becomes especially useful when you want to compare two projects of the same rate of risk. Be careful with it though as the risk of each investment might differ. You cannot say, “Yes, with rate of return at 11% we should definitely go for it because the interest rate we would get in a bank is just 3%.”

The interest rate that you get in a bank is risk free. You need to adjust the returns to the rate of risk of each investment if you want to compare two or more projects with a different probability of failure but that is a topic for another article.

# MRR

This measure is just informative and serves a potential future investor to see the profitability and independence of a project. Relatively speaking you should aim for €80–100K of MRR for series A funding. As I said this is very relative and might vary from business to business. I am mentioning this measure to give a broad idea of what a potential investor might expect. It is worth calculating for you to know when the project is “ready” for series A funding and your colleagues to have a benchmark or an idea when the investment could occur so to speak.

# Test the sensitivity

It is really hard to predict how costly the project will be, how you will benefit and at what risk all this will happen. You must test how sensitive the outcome of the project will be to your key parameters.

This will be your final step before you do your final decision or recommendation. It is essential to know where the drawbacks are and what are the most sensitive variables.

For example, every small change in your customer base can cause a huge drop in sales revenue or one more employee in your team will shift the expected break-even point by a year.

Your final decision should take into account the sensitivity test and be ready to work with different scenarios.

Also do not forget to constantly update parameters as they might change from day to day.

# Final remarks

When you do such an important piece of work in your project always remember to put your preexisting beliefs and biases away as far as you can. A cost-benefit analysis should not feed your excitement, rather it should tell you “Okay this might look good on paper but does not make sense in numbers”. Also, do not be overly optimistic especially when it comes to expenses. It is always easier to calculate what you can earn and get excited about it but the expenses will tell you if you should or should not forgo the project.

The whole analysis will be based on assumptions and estimates. If you are unsure about some of them do not hesitate to ask your colleagues. They might give you a different perspective on a matter and help you move forward. Be prepared to justify every estimate or assumption you make. Although it is only a “guess” it should be supported with some evidence from your search of the market.

Calculators out and GOOD LUCK!!

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