Thursday, July 12, 2007

[New Biz] Will it Work? Creating a Financial Model

It's not exactly a legal concept, but one of the things I try to get my start-up clients to do before starting their business is to put together a very clear financial road map before doing anything. You would be surprised at how many people skip this critical step.

I should also add that this is not a completely new business concept for me. I am presently a partner in a company that holds the lease where my office is currently located. That business is run more like an "expense co-op", not a for-profit business. But nevertheless, I created the operations and financial systems we use to run the office suite, I played an integral role in the build-out and marketing the space, and I am intimately familiar with the economics of subletting office space. This new concept is just an extension of what I am doing already, which is also a "best business practice":

Make sure you have some experience in what you are trying to do, and actually enjoy doing it before starting the business.

Space was available in my office building, but empty space, even downtown, was going fast. I needed to move quickly if I wanted the best, and most affordable space. For strategic reasons, I specifically wanted the identical space I have already, just on the floor below where my office is now. There was no time to put together a formal business plan, but I needed to get clear around the numbers to see if the idea would work before committing to renting a space for 5-figures a month.

got a quote from the Super in the building on the range of current rent rates in the building and learned that rents for the same amount of space I presently lease have increased by 40% in two years.

I had my bookkeeper run all the expense numbers for the previous two years in my existing space. I then I went back to my records to see what the build-out costs were, making adjustments for things I would do differently.

Then, I added in a factor for advertising (we didn't advertise to fill our current space), 15% inflation from the old numbers and a 20% fudge factor on the build-out expenses. In terms of revenues, I ran a worst, middle and best-case scenario and determined my break even point for each scenario based on my experience renting offices in my current space, and what other people were offering for similar spaces.

Running a simple spreadsheet, I learned that I needed to rent between 50% and 60% of the offices to break even. Anything over that, including "add-on" services and non-rent sources of revenue were extra profit.

From experience, I know that once an office is rented, for a number of reasons, professionals are reluctant to move. So even if renting the offices takes me longer than expected and I ran at a loss for a short period of time, I could make up the difference over the life of the lease time because it was unlikely to have more than a 10% vacancy rate at any one time.

The only unknown was marketing this value-add system I plan to create, and whether there was a demand for it. Basically, I did some preliminary market research and talked to some lawyer buddies and networking contacts to see their reaction. Nearly all were enthusiastic about the concept, but reluctant about the overall risk in taking on the project (which I expected because lawyers, who spend the majority of time getting paid to spot and minimize risk for clients, are often terrified of taking any risk themselves).

So my financial model, while clearly not perfect, demonstrated to me that there was a high probability to generate a good profit from the model, and while there was some up front risk, most importantly that I would have to fill 60% of the space in 90 days, over time, it was going to be easy to recoup any start-up losses, and that if I wanted to grow the business by taking on more space, most of my start up investment in equipment could be leveraged, thus increasing overall profit margins (to a point).

My analysis got me comfortable enough with the number to the point where I was willing to invest my own money on the concept. My next call was to the landlord to start negotiating a lease.

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