Before you bring in investors, you should have a plan for how your cannabis start-up will make money. The first step in developing that strategy starts with creating a business model, the essence of any solid business plan.
Tim Wasik, president and portfolio manager at asset management firm Mahogany Asset, explains that “It's important to have a business model because it really gives [investors] an idea of how you plan to execute your business, how you plan to make money, and is also an indication of whether you actually understand the business and understand what you're doing as well.”
Here are three essential factors to consider when developing a business model for any cannabis company.
Consciously making an effort to define your target customer can separate the people and organizations you aim to serve. Ask yourself what problem your idea solves, and for whom? Knowing your customers, the problems they face, and how you can address those issues can add to your value proposition.
For John Prentice, founder of cannabis start-up success story Ample Organics, the problem and solution arrived in tandem. Prentice was working with Peace Naturals in the early 2010s as they were readying to become a licensed producer.
“At the time, there was no alternative,” he recalls. “What we ended up doing was building custom software to handle patient ordering, inventory tracking and all the kind of stuff that we needed to get by with the regulations. It was great to be able to work inside of Peace, and understand how their business works and build the software around systems and processes that they had in place.”
Now, Ample Organics is a leading seed-to-sale software company that was recently acquired by Colorado’s Akerna, a company that specializes in cannabis regulation compliance software. For Prentice, getting that inside look at the burgeoning cannabis industry allowed him to see a place for a service he could provide.
He also recommends that businesses really work to maintain a focus in their early days when it comes to their value proposition. “The biggest mistake IT start-ups make today is just a complete lack of focus,” he says. “They take on too much all at the same time and really not focus on what's the core proposition or why their customers are coming to them in the first place. Talk to your customers and understand what's most important to them, and then don't focus on anything else until you're finished. It sounds really simple, but it's something that I don't see a lot of.”
A profit formula is an element that interlocks with your value proposition by outlining in clear terms how your business earns revenue while providing to your customers. Equations that outline your costs, resources, and revenue will help identify your value proposition.
Revenue: a key performance indicator for all businesses. Your revenue formula is the price of your service/product multiplied by volume (market size, purchase frequency, ancillary sales, etc).
Cost structure: the various expenses your business may incur, typically broken down into fixed and variable costs.
Margin model: the amount that each transaction should net to achieve desired profit levels.
Resource velocity: the speed with which resources need to be used in order to support your target volume.
As an investor, Wasik also cautions that outside of those basic equations, it’s important for start-ups to have a sense of the working capital they’ll need to finance their business’ growth. Working capital is the difference between the company's operating assets (like cash, accounts receivable, inventory), and their operating liabilities (accounts payable, debt, taxes). “This is what happens with a lot of companies: they start selling, they have some success, and then all of a sudden they realize, ‘I need more money.’ Well that's because you didn't plan for success,” he explains. “If I'm going to make $10 million on gummies, I'm going to have to pay a lot of the costs upfront. I'm not going to get the revenue for 30, 60, 90 days. So as you ramp up, I need to have that working capital to support the growth.”
Prentice agrees, adding, “Raising money, people would have a lot of questions about our total addressable market.” By this, Prentice means the revenue opportunity or demand available for a product or service at the point of 100% market share. Total addressable market is the maximum amount of revenue a business could possibly generate via that product or service. “So when we started business planning in the very early stages, we knew that having cash up front would be critical to be able to fund operations moving forward. So it really prompted us to adopt a revenue model that was more cash incentive up front, and then we transitioned into a software as a service model later on once we reached critical mass.”
What people, technology, products, facilities, equipment, and branding are required for you to deliver the target value proposition for the consumer? What operational or managerial procedures like training, research, budgeting, or sales will allow you to deliver value in a way that can be repeated but also increase in scale?
It’s a fine balance of needing to be mindful of your business’ needs up front, while also planning for growth. If anything, Prentice recommends keeping as lean as possible. “It's really easy to look at a problem or a challenge and naturally think that applying more resources or talents to it is going to fix it,” he says. “That’s not true. Throwing more bodies at a problem just makes for a bigger problem. Entrepreneurs need to be very cautious to try and keep their head count as low as possible at all times.”
Taking the time to understand your customer, what they value, and how you can deliver it at an appropriate cost can be a complex and time consuming exercise. Taking these steps will help ensure you start off on the right foot, as they can signal to investors that you know what they’re doing and have put the work into not only formulating your idea but building a proper plan around it.
“As an investor, to be blunt, we're here to make money,” Wasik says. “And we want to know how out of these companies we are going to make money and, and generate cash, which allows them to reinvest into the business or acquire other businesses and get bigger and bigger. So it is very important how to understand how to make money."
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