As we scroll on our phones to pass time, we constantly get flooded with targeted ads for new products. Whether it’s for the latest iPhone or a knife so sharp that it can cut through pennies, the appetite for new products and services is a common, daily pang. The level of demand has no ceiling, which is essential to keep the gears moving in companies and innovation thriving.
One of the key responsibilities of Finance professionals is to run the litmus test on potential new offerings. By partnering with key stakeholders and building financial models, they can assure offerings are financially sound and will have sustained value through healthy operating profit streams and alignment with company strategy.
In working with many Product Development and Marketing teams, I’ve seen many an excited Engineer or Marketing Director charging towards me with a gleam of excitement in their eye. They have an idea(!) for the next product that will be a growth catalyst for the company. It is important to keep the excitement but imperative to understand and evaluate how that idea will be successful. As the famous C.D. Jackson noted, “Great ideas need landing gear as well as wings.” In this article, we will shed light on some key tools to help navigate through new offering decision points.
Building Financial Models: Understanding the Size of the Prize
Analyzing the market space and competitive landscape is the proper origin for building a financial model to explore the potential for a new offering. Often in pitching a new product, a Board or Investment Group would first seek to understand the size and characteristics of the market. The market can give an indication of how much the company would need to scale to support the product—or even offer signals to how long the product lifecycle would be in the given market.
Three measures to help understand any market are TAM, SAM and SOM:
Total Available Market (TAM): Annual Revenue x Companies in the Market
TAM represents the total market for your product or service. In most industries, the potential product should feel like a small fish in a large pond with this measure. This gives an idea of the space that the new offering can expand and how freely it can transform within the industry bounds. Investors look at this measure to understand how much the company would need to scale to be a key player in the industry and support the product.
Serviceable Available Market (SAM): Target Segment of TAM x Annual Revenue
SAM starts to filter down to a more specific audience you are trying to reach with your offering. Most of the time, this is filtered to a region or segment level. There is usually a significant decrease between the TAM to SAM measure. The SAM is a vision of the possible market share the company can gain over a period of time and evolution.
Serviceable Obtainable Market (SOM): SAM x Prior Year Market Share
SOM narrows the SAM market to the space that you can obtain with your current operating model, which includes current resources, competition and pricing thresholds. SOM is often modeled as the top line in financial growth calculations.
Understand Market Share: Key Metrics
Build vs. Buy
In the Tech industry, the question of “Build vs. Buy” is integral in deciding how to launch a new product. The question has often come up in my experience, particularly with software companies. There are many components that drive this decision, with the top factors being:
- Budget – Modeling the most cost optimal solution that doesn’t sacrifice the quality and timing is key. If there are current resources that have adequate utilization to create your new offering, you might be leaning towards Build. More and more, we see firms partnering and working with third parties in lower-cost geographies to create a low-cost ecosystem in a Buy view. If a company decides to go the Buy route, it is imperative that clear service level agreements are set, so the milestones and timelines are met.
- Scale – One must ask, “Is the company on its own equipped to create and support the new offering?” People usually think scale is only tied to personnel, but other factors, such as infrastructure, also come into play. I’ve had one experience where a partner company was chosen to provide the “Scale” work and ultimately became a possible candidate to be acquired, which can be very beneficial to the growth and lifecycle of the product and branching out into further offerings.
- Quality – If the company does not have the skillset to launch the new product, and it will be too time consuming to hire a team, they might lean on a third party to provide the skillset. Specialized skillset companies can be quite pricey, so it all must be managed to the budget.
Building Financial Models: Cost Categorization
In most cases when building financial models (e.g., ROI analysis, cash flow forecasting) in the immediate timeframe, quite a few different types of costs would align with an income statement or project analysis statement (e.g., engineering, marketing, materials, rent). It is beneficial to the stakeholders to categorize costs as One-Time and Run-Rate:
- One-Time Costs represent the expense to get the offering off the floor, which can span from the first year to even the three-year mark. These costs are not repeatable when the product goes to a steady state.
- Run-Rate Costs would be the ongoing costs to keep the product at a steady state. The goal is to maximize efficiency in your run-rate state to benefit profit.
Companies are segregating their investment into this model (especially PE- and VC-backed firms) as this method approaches these costs as investments, which benefit and maximize the Run-Rate EBITDA for optimal valuation.
Establishing pricing on new offerings is a balancing act that is tied to the market share analysis mentioned earlier. This takes significant collaboration with the Sales and Marketing team. I’ve seen the pricing from both sides of the coin. Sometimes the pricing is extremely high as there is elevated customer demand, deep pockets and companies have exclusivity in terms of supply. On the other side, pricing starts out lower than usual to penetrate into segments and geographies to build credibility.
It’s important to model pricing in a phased approach that can follow the product lifecycle, noting gross margin could be lower than anticipated due to discounted pricing to gain customer traction (unless efficiencies are found in COGS). Running a pilot on pricing scenarios and offerings will also help get a feel for the market’s reaction to your new offering. Commercial pricing structure is more important these days, as most companies are aligning to a subscription model or negotiating on payment terms. This approach helps the company understand how to align with the demand and marketplace.
Partnering with companies on creating new products has been a great experience for me, as it’s an interesting sandbox in which a Finance professional can merge his or her financial toolbox with creativity. It is truly a team effort to lead a product to success. As we see product lifecycles shorten, and demand for the next shiny object grow, the role of a Financial partner will become more crucial in understanding and nurturing an innovative idea into a successful offering.
Learn More About Building Financial Models
To learn more about the process of building financial models, you can download our financial forecast process guide. If you’d like support from our team of finance and accounting consultants, you can also contact us to start a conversation. We’d be happy to help!
About the Author
Romesh has 15+ years of experience in leadership positions for multiple global companies encompassing Technology, Market Research, Food & Beverage and Financial Services industries. Prior to joining 8020, Romesh had financial ownership of the Cloud Ethernet testing and Security Solution Divisions. During Romesh’s time at JD Power, he was a key lead of the $1+ billion sale to private equity firm XIO Group from S&P Global, which included complete carveout and standalone workstreams. His areas of expertise include P&L management, financial planning & analysis for business units and corporate consolidation levels, strategic planning, acquisitions including carveout and integration, investor relations and operational finance (e.g., Sales, Marketing, Product Development, Treasury). Romesh also has experience working directly with company boards and private equity firms. Romesh holds a bachelor’s in Business Administration from Pepperdine University.
Categorized in: Financial Planning & Analysis