How to model revenues

How to model revenues using the top-down and bottoms-up approaches.

Let’s start modeling your revenues by estimating your market size. Why? Understanding your market size is critical (market beats all) and will be a core component of any of your fundraising conversations.

For an idea, or a pre-seed or seed stage company, it’s not necessarily important to have detailed financial projections. Instead, what you need is an understanding of the market size and dynamics, and how your product solves a problem in the market. The more evolved your business becomes, the more detailed projections you’ll want to build.

Let’s start by creating a sketch of the market.

First: Understand your market

  • How big is the market? (How much money is spent in the space?)
  • Of the overall market, how much of it is “addressable”, meaning how much of the market are you targeting and could reasonably count as a potential customer?
  • Once you have the “addressable market”, or sometimes called TAM (Total Addressable Market), now you have your market size.
  • Create a short summary, or a chart or graph, that shows the total market and the total addressable market, and explain how you estimated the addressable market.
  • If the market is changing, make sure to explain that. Is the overall market growing, or staying the same? Is the market shifting? Explain the dynamics and how you are building within those dynamics.

Data might be hard to come by, but keep looking, and when you don’t know, create the best estimates you can with the information you have, and note how you did it. Being able to explain how is more important than complete accuracy.

Second: Understand your per-user economics

The important thing here is to be able to have a basic idea of how much money you can make per-item, per-customer, per-whatever metric matters. Focus on your direct production costs, which will be very different depending on the type of business you are.

Outline your basic per-unit costs and what you can expect to be able to charge. That will give you an idea of how much margin you make from a single item, a single customer, etc.

For level-setting and benchmarking, start thinking about your type of business. For a SaaS business, is your LTV (long-term value) > CAC (customer acquisition costs)? For a transaction business, how many customers / items do you have to sell before you can enough money from sales to pay for your fixed costs (people, office, etc.)?

That will give you an idea of whether your cost structure makes sense, how much of the market you have to capture, and how big of a business you have to be (scale) to be profitable. This analysis will give you the top-down sketch you need for the early-stages of your business (and your financial model).

If you’re at the really early stages of your business and your idea, and even if you’re fundraising from early-stage capital, this might be as far as you go. If you can convince someone that a) there’s a large, available, willing market to sell into, and b) that your user economics work, then the question becomes less financial and more executional, meaning can you convince someone that you can execute the business to achieve those economics and capture that market.

Market Share Revenue Forecast

The next step could be to create a top-down revenue forecast where you forecast out your addressable market, then assume a percentage of the market that you think you can capture, and by multiplying the two you’ve created a top-down revenue forecast based on market share. This typically sounds like: “We have a market size of $500 MM. If we capture 2% of the market, our revenues will be $10 MM.”

While easy to do, this type of revenue forecast doesn’t provide much detail into what you have to do in order to capture that market share, and the lack of operational metrics - customers, prices, etc. - doesn’t provide a) you much of a guide to work with or b) much of an indication to potential investors that you know what it takes to achieve that market share.

It’s a good starting point and benchmark, but the next step would be to create a bottoms-up revenue forecast, starting with modeling out the key operational metrics that drive revenues.

User and Customer Estimates

Estimating users (customers, clients, et. al.) is really hard, and you’ll be wrong no matter what you do; but that doesn’t mean it’s not valuable, because estimating users is a valuable way to benchmark your model. How many do I have to get to be profitable? How many months does someone have to be a SaaS customer? How many in-app purchases do I have to get someone to make? It’s easy to get lost in the details, but start estimating users by using whatever data you have on performance to date, it’s the best starting point. And then break out user acquisition into a couple channels:

  • Paid marketing: Facebook, Google, Twitter, etc. The key here is to use the estimates of marketing spend you created earlier and attach some metrics to them, like CPC (cost-per-click) and CPM (cost-per-impression) to figure out ow much $$ in spend translates to ads, and then click and conversion rates to estimate how many of the clicks turn into customers. Conversion rates from pageviews from ads are terribly difficult to estimate, but they’ll be low. Sub-10%, sub-5%, sub 1%, most likely.
  • PR, press, viral: I usually lump these together, but the important one is viral. You can model viral growth by estimating the # of people who invite others * the # of people that each person invites * the % of those invited that convert , which results in a viral coefficient (>1 means the product can self-sustainably grow virally). But more important than these estimates are thinking about how your product can grow virally: what viral hooks exist in the product? Where are things shared? How do people convert? How efficient is the process? What is your viral loop?
  • Direct sales: B2B companies have another obvious set of channels, consisting of outside sales and inside sales staffs, with their own plans and teams and structures. The key here is leads, lead nurturing, lead conversion, and the staff you’ll need to support sales.

Once you have a good idea of user acquisition estimates, then you’ll be able to understand your acquisition costs and estimate your customer acquisition cost (CAC), and important metric for understanding your business model.

Revenue Estimates

Building on our user and customer estimates, next is to build a bottoms-up revenue estimate. A bottoms-up revenue estimate is created by taking a line-by-line approach to estimating customers and the applicable revenues. The approach is more detailed than a tops-down approach, and it’s far more valuable as well. But it’s not because it’s “more accurate” or “correct” than a tops-down estimate: a bottoms-up approach is more valuable because it creates valuable insights around marketing, product, expected sales and adoption.

What I typically do is think through each action and interaction that leads to revenue. Calculate your numbers and lay our your spreadsheet anyway you like, but make sure you think through how the product works and how it generates usage and revenue. If you do, you’ll create a bottoms-up revenue estimate that can provide meaningful insights into how your business works.

The Foresight models take two basic approaches to revenue forecasts: the Runway and Cash Budget Tool and Starter Financial Model do not have any prebuilt revenue structures, so you are free to create whatever forecasting methodology you want, whether it’s a top-down, simple or detailed bottoms-up. The Standard Financial Model has an extensive prebuilt bottoms-up approach to revenue forecasting that models multiple acquisition methods and models a two-step conversion funnel, creating detailed operational metrics behind the revenue forecasts. To learn more about that, see The Default Revenue Model.

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