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Digital products can make your business highly scalable and highly profitable. But they require a substantial financial investment to launch and time to scale. An early financial model for a new digital product clarifies your revenue and investment assumptions (and the resulting cash flow and profit/loss) in the first few years before you write the first line of code.
A digital product business’s financial dynamics are likely very different from what you have experienced. Before investing in a digital product, you should have a financial model to develop a realistic picture of what to expect regarding future revenue, expenses, and potential ROI of this investment.
Build Your Digital Product Upon a Solid Foundation
The potential for reach, scale, and profitability is why leaders pursue digital product businesses and make investments. However, it takes time to build that recurring revenue base. A financial model clarifies what you can expect while building, launching, and scaling your new digital product over the next 3-5 years.
However, budgeting for software is not as definitive as buying a car or building a house. It's more malleable than that. The first financial model for a digital product should prevent you from getting caught up in minute details like month-to-month customer acquisition forecasts that can become overwhelming in the early stages.
You Need a Tool to Plan for Your Product’s Lifecycle
Just as you wouldn't begin a journey without mapping your route, starting product development without a financial model will lead you off course. You risk creating a desirable and feasible product but not economically viable.
A strategic financial model pressure tests your thinking about product pricing, customer numbers, and the revenue needed for profitability. It aids in planning for the first few years of your product’s life – which often requires substantial investment in scaling and marketing before generating revenue.
Failure to set realistic expectations for expenses and revenue can trap entrepreneurs in periods of intense pressure — whether that is from expectations you set for yourself, your bank account, the business profits you're investing in, or your investors.
A Financial Model Shapes Your Digital Product’s Scope and Direction
When creating a digital product, time truly is money. The longer it takes to launch your product, the more it costs, and the longer it takes to generate returns. A financial model serves as an invaluable guide for the road ahead and provides governance for the countless product and team-related decisions you’ll make.
Identify Who is Likely to Buy Your Product
The number and type of customers buying your product are the foundation for estimating revenue and expenses. Many small customers in a large market can create faster scaling but with higher churn and require larger marketing and product investments. Fewer larger customers in a smaller market may scale slower but have much lower churn and require larger sales and support investments. So begin by estimating your addressable market. Who are your potential customers, and where are they located? Typically simple internet search will yield the kind of sizing information needed at this stage, based on census information and other data platforms, as well as the size of any existing providers in the market.
Assume a plausible market share and establish pricing based on your estimated customer base.
Start by Setting Some Revenue Benchmarks
The timing of revenue is difficult to predict. The goal at this stage is to create a believable, conservative picture of when revenue starts being generated. Aim to get in the ballpark with realistic assumptions. The goal at this stage is to set high-level expectations and prepare for a reasonable investment and timeline to get to success.
First, you need to decide on a pricing level. Most digital products use monthly or annual subscription models that scale by user or another usage factor. Keep your pricing model simple for this exercise. If you truly expect to have multiple pricing levels, choose what you think will be the average price.
When forecasting your revenue, calculate your total addressable market and set a conservative goal of capturing that market 4-5 years in the future. We would strongly recommend less than 10% market capture unless a product meets a particularly strong unmet need and/or your current reach into that market is very high. Then model a growth curve to that target starting across years 1-3, with a slow start in year 1 and accelerating as you go. As a rule of thumb, we recommend cutting your target year 1 revenue (the year after product launch) in half, as you’ll be bringing on new customers throughout the year and not all at once at the start.
After year 1, factor in new customer revenue and expected returning customer revenue for each forecast year. Don’t forget to build in a churn rate for your existing customers to gain a clearer picture of how many new customers you’ll need to acquire.
We recommend forecasting revenue by years instead of months at this early stage. In our experience, forecasting by months doesn’t improve accuracy and can result in overly optimistic assumptions.
Get Detailed About Your Expected Expenses
On the expense side, take into account product development and maintenance costs. An experienced consultancy like Highland can give you a pretty solid estimate of these expenses.
Your major initial capital expenditures will be for digital product design and development and–usually–for product branding and early marketing.
Over the long term, your common operational expenses will include:
- Marketing
- Digital Product Design & Development
- Sales Team
- Service Team
- Infrastructure / Managed Service
- Executive Leadership
Evolving Your Financial Model
Remember, this isn't a one-time process. You’ll likely be adjusting your assumptions about pricing, timing, and expenses while building your model as you see the implications for annual profit/loss and cash flow. This change will continue as you enter the market and adapt to ever-changing market dynamics and realities. Creating a financial model is an ongoing balance of estimation and adjustment.
Investment in a Digital Product Is Only Half Over At Launch
The investment in a new digital product business goes well beyond its launch. The cost of building a digital product can be significant, but it often represents roughly 50% of the total investment required before a product typically begins returning a profit and ROI.
The early life of a digital product after launch into the market requires continued investment in the product and additional investment in marketing, sales, and customer service. That investment mix depends on your go-to-market strategy and what kind of customer you’re serving. While you can and should plan to do these as deliberately and efficiently as possible, a realistic cash flow forecast allows you to plan more accurately for the early years of your digital product business.
You can see this dynamic in the cash flow forecast chart below, where cash flow continues on a negative trend into year 2 in the market before beginning the hockey stick growth associated with successful digital product businesses.
Your financial model will continue to be crucial for comparing your digital product’s performance against projections, providing necessary insights for course corrections.
Get Clearer Guidance With an Experienced Partner
At times, entrepreneurs can be overly optimistic or underestimate their product's potential. The Highland team can ground these expectations without extinguishing enthusiasm and uncover underserved market segments, leading to new opportunities.
Experience teaches us that understanding costs and potential returns are not a mere side activity but integral to the success of a digital product. A robust financial model grants a comprehensive view of the costs associated with building, scaling, marketing, and maintaining your product. Beyond budget planning, this model lets you foresee your potential return on investment.
We know how important your digital product is to you, and we are committed to responsibly guiding our clients to make smart financial decisions. We want to ensure that the product you've been dreaming about has the proper runway to get off the ground — not crash and burn.
If you’d like to learn more about creating a financial model for your digital product, ask for a free conversation about your financial model with a Highland principal.
