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February 28, 2021

Business Models – Glossary

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Below is a look at how to understand the lingo when looking at terminology related to business models, along with some examples of where you might see them on the site to put them in context.

This Glossary is meant as a guide to help assess business models and their corresponding analytics/metrics, as certain terms are typically associated with specific industries and can be confusing when looking at entire business models or segments. Some terms have specific meanings in accounting (when a public company discloses their quarterly financial performance, for example), but are used interchangeably in finance and entrepreneurship to describe a business model’s performance. This Glossary is not meant to be an accounting guideline, but rather a language guide for understanding business models across a spectrum of industries as analyzed on this site.

Financial Terms

These terms are commonly discussed when assessing financial performance of a given company, especially during quarterly earnings. There is a lot of nuance to each set of terms, and the context of usage for a specific term can lead to very different levels of understanding of how a business is performing.

GMV (Gross Merchandise Value)

The Gross Merchandise Value usually is representative of how much total value businesses (typically eCommerce and Retail) move through their platform in a given period of time. This is not how much Gross Revenue they make, it is simply a metric to show the volume of goods being purchased through the business over a given period of time.

Farfetch Q4 Earnings 2020

Revenue or Gross Revenue (Top Line/Turnover)

Revenue is the money earned for the sale of each good/service. Sometimes it is referred to colloquially as the ‘top line’ (or ‘turnover’ in the UK).

In a business model like Farfetch for example, which earns a commission on the sale of goods sold on their platform, their revenue would factor out the GMV x % Commission Earned.

Farfetch Q4 Earnings 2020

In other businesses, the Revenue is simply the cost of the good/service as it is sold to the customer, multiplied by the # of units sold over a certain period of time.

Ex. $1,000 x 25% Commission = $250 Revenue

Ex. $50 per good x 500 goods sold in the quarter = $25,000 Revenue

Take Rate

Take Rate is a term often used by eCommerce businesses to quantify the average fee (ie. Commission) that they take on sales over a certain reporting period.

Payment processors such as Paypal also state their Take Rates, along with marketplaces such as Uber.

>DoorDash example

Take Rate, defined as Revenue as a percentage of Marketplace GOV, was 11.9% in Q4″ DoorDash Q4 2020

>Uber example (Mobility business)

“revenue recovery lagged Gross Bookings recovery with take rate declining 140bps QoQ to 21.7%Uber Q4 2020

>Farfetch Example

“Third-party transactions generated 84% of Digital Platform GMV at a take rate of 28.8% in fourth quarter 2020″ Business Wire – Q4 2020

>PayPal Example

“PayPal consistently generates take rates in the low 2% range” Investor Place – Q4 2020

COGS (Cost of Goods Sold)

Cost of Goods Sold usually are related to the variable costs associated with the sale of goods for a given business.

These are costs that are typically directly related to the sale of the good or service, such as cost to produce the good, packaging, landed shipping cost to the business (not the customer), etc.

It does NOT include staff salaries, Sales & Marketing expenses, or other expenses typically associated with General & Administration (G&A), such as rent.

Net Revenue

Net Revenue typically measures Revenue minus (-) COGS + Discounts + Returns, etc.

It isn’t a term applicable to all businesses, but for some businesses (like retail, eCommerce, etc.) it is important to understand Net Revenue.

Cost of Revenue

Certain platforms will state their COGS alternatively as Cost of Revenue. DoorDash’s Q4 2020 Earnings report illustrates how this looks below. This metric is commonly used, as illustrated below, to calculate Gross Margin for a given business.

DoorDash Q4 2020

The devil is always in the details when it comes to what is included in ‘Cost of Revenue’ for each specific business.

Where Cost of Revenue differs from COGS is that it includes costs related to actually generating the sale, such as distribution (ie. shipping to the customer, delivery of the good to the customer). With DoorDash, you can see how this line breaks down compared to other major expenses, which are typically categorized as Operational Expenses (OpEx).

DoorDash Q4 2020

Margins:

Overall, the term ‘Margin’ generally refers to the amount of money earned when you subtract the revenue from the variable expenses related to the sale of the good/service (ie. COGS+). It can be presented as a dollar value or as a % depending on the specific context.

Gross (Profit) Margin:

Gross Profit equals Revenue minus (-) COGs.

Gross Profit Margin expresses this equation as a percentage, and is an extremely common and useful metric for assessing the strength/weakness of any core business.

Farfetch for example, breaks this number out in their Quarterly reporting.

Farfetch Q4 2020
Farfetch Q4 2020

Gross Profit Margin (%) = (Revenue minus (-) COGS) divided-by (/) Revenue

Using Farfetch’s data from their recent Q4 2020 Quarterly report:

540,105 – 290,957 (249,148) / 540,105 = 46.1%

The higher the Gross Margin the better.

Operational Expenses (OpEx)

When you look at the operational expenses for both Farfetch and DoorDash in their recent quarterly reports, you will see that they have similar – although slightly different – operational expenses.

DoorDash Q4 2020
Farfetch Q4 2020

Sales and Marketing Expenses (Demand Generation Expense)

More commonly referred to as ‘Sales and Marketing‘ expenses, but Farfetch refers to it is ‘Demand Generation Expense.‘ This is because these expenses typically include ALL expenses related to acquiring new customers including:

>money spent on digital/print advertising campaigns

>money spent on agencies, PR, etc.

>staff salaries related specifically to sales and marketing

Investors will pay a lot of attention to this metric because it usually enables them to understand CAC (customer acquisition cost) which is covered below.

Research and Development (Technology Expense)

This is money that is typically allocated to development of the digital platform and corresponding technologies. DoorDash refers to this expense as ‘Research and Development‘ whereas Farfetch calls it ‘Technology Expense.’ That doesn’t necessarily mean they are exactly the same expense, but generally these cover platform-related technology/R&D for these types of companies.

It is a very important metric when looking to assess any business model because typically these companies’ platforms are their growth engines and continuous investment is required in technology in order to keep innovating in uber-competitive markets. When you look at the ‘Cost Structure’ on many Business Model Canvas’s, you will see Platform R&D/Development as one of the top ones, especially for companies that are just starting out.

Uber’s business model, for example, has a very unique breakdown of this type of ‘Platform R&D‘ versus their ‘ATG (Advanced Technology Group)’ expenses.

Uber Q4 2020

The calculation and weighting of the ‘platform’ expense can have a significant effect on profitability. Many companies in today’s world continue to invest $Billions in their platforms at the expense of short-term profitability, as they instead bet on the long-term market share gains and technological superiority.

Depreciation and Amortization

Depreciation and Amortization is an expense typically related to physical equipment, where each year a certain % of the capital cost to buy the equipment is amortized (depreciated) as an expense on the Income Statement (the remaining capital is usually stated as an asset on the Balance Sheet).

DoorDash has very little Depreciation and Amortization expense related to its delivery business, whereas Farfetch has significant Amortization expenses related to its technology platform and Depreciation related to new leases they have signed according to their earnings report.

G&A – General and Administrative

This expense can generally end up combining a lot of items related to ‘Administration’ of the business, but generally it includes all executive salaries, rent, etc.

You can see that with Farfetch, for example, this is their biggest expense – more than 2X the next closest line item. Whereas for DoorDash, Sales and Marketing is more than 2X their G&A expense. A lot of this depends on the phase of the business and the strategy.

Profit:

Once you subtract Operational Expenses and Taxes from the Gross Margin, you end up with either a positive (or – negative) profit for each reporting period.

This number can be reported in a number of different ways on any given company’s Financial Statements, given all the accounting considerations in each respective business. This is why ‘Profit’ is commonly reported as EBITDA.

EBITDA: Earnings Before Interest, Tax, Depreciation, and Amortization

DoorDash Q4 2020
Farfetch Q4 2020

You can see how differently DoorDash and Farfetch report EDITDA. DoorDash refers to it as ‘Loss from Operations‘ while Farfetch calls it ‘Adjusted EBITDA.’

Without getting into forensic accounting to better understand exactly how each company comes up with these numbers, this is basically EBITDA.

Whether or not a business has positive EBITDA is not the be-all and end-all for investors, but it does mean that if a company is losing money on a quarterly or annual basis that they are burning through their cash reserves. If you are turning a Profit, you will be bringing cash into your accounts, whereas if you are not then this will mean you are burning cash. This may require future equity fundraising or debt issuance depending on how long a company goes before becoming profitable.

Net (Profit) Margin:

Once a company is profitable on a consistent basis, you can measure ‘Net Profit Margin,’ which is calculated by:

>Net Income divided by (/) Revenue.

Understanding the ratio of Net Profits to Revenues is another good metric for investors to understand how strong a business model is over the long run.

Unit Economics Terms

These terms are usually used to gain quick insights into performance metrics of companies, especially in relation to peers. They are not always an exact science, but can be indicative of either big problems or big potential for a business.

AOV (Average Order Value)

Average Order Value is a term that is very commonly associated with eCommerce business models. If for example:

>Order 1 = $40

>Order 2 = $50

>Order 3 = $30

Average Order Value = ($40 + $50 + $30)/3 = $40

This is commonly representative of the order value (ie. merchandise value) for a given business, not the actual revenue earned by the business.

ARPU (Average Revenue Per User)

Average Revenue Per User typically refers to the amount of revenue, on average, earned from each customer over a specific period of time. Normally this is broken down as a quarterly or annual number. For example:

>Customer 1: Spends $300 in Year 1

>Customer 2: Spends $400 in Year 1

>Customer 3: Spends $700 in Year 1

Average Revenue Per User = ($300 + $400 + $700)/3 = $467

One would typically endeavour to increase ARPU over time. A decreasing ARPU could have significant implications for the health of a business if it is anything less than a short-term blip or related to a large unexpected event.

This metric does not equate to total revenue for the business. A new company could have very few customers, but have a very high ARPU and that would be a very positive indicator of future success, for example.

CAC (Customer Acquisition Cost)

CAC covers all of the ‘demand generation expenses’ related to customer acquisition. As a quick example:

>You acquire 100 customers in a 3 month (1 quarter) period

>You spend $5,000 total in salary for marketing staff

>You spend $3,000 total in digital ads

>You spend $2,000 on a part-time PR firm

Customer Acquisition Cost = ($5,000 + $3,000 + $2,000)/$100 =$10

This would mean that on average, you spend $10 to acquire each customer. This is an extremely important benchmark in relation to how much AOV and/or ARPU are.

Churn

Churn is the % of customers who leave a business. This is typically associated with SAAS (Software-as-a-Service) businesses that have recurring revenue streams, or Subscription businesses like certain media platforms.

Progressively, however, the metric is making its way towards retail/eCommerce businesses that are benchmarking loyalty as the % of repeat purchases their top customers are making.

Overall, the lower the Churn rate the better for the health of the business. Having loyal customers means less money is typically spent on marketing to acquire new customers, and more money is earned from those companies on a long-term basis.

Net Promoter Score (NPS)

In relation to Churn and Customer Loyalty, we have NPS, which is commonly a soft metric that measures customer satisfaction in relation to a given brand or product/service.

Understanding NPS

Many brands will ask this question in followup surveys or emails – how likely are you recommend XyZ to a friend?

You can see above that there is a relatively simple formula to calculate NPS from the responses, and the higher the number the better. It is also another metric to help companies understand customer loyalty.

We would refer to it as a soft metric in relation to the above because unlike all the other metrics listed under ‘Unit Economics,’ it is not based on financial data pulled from the business. It is survey-based data, which can be somewhat unreliable depending on the context. Nonetheless, NPS is a good indicator to be aware of.

LTV (Lifetime Value)

Lifetime Value (or Customer Lifetime Value (CLV)) is another metric typically associated with SAAS or subscription businesses, but one that is starting to gain more traction in retail/eCommerce thanks to companies like Farfetch, as we talked about the in CBCV (Corporate Based Customer Valuation) framework.

The main thrust of LTV is that is that if you acquire customers today – and retain those customers – then over the long-term (several quarters or years) those customers will spend a certain multiple of what it costs to acquire them.

If this ‘LTV/CLV factor’ is greater than 3X (or 300%), this is considered excellent. This can be a somewhat complex metric to explain for non-subscription businesses, but in Unit Economics terms it helps measure the ROI on marketing spend over the long-term, and can play a predictive role in determining how well a business will perform in a given sector versus another business.

Financing/Fundraising Terms

These are but a few of the common terms used when discussing financing or fundraising, especially in regards to innovative/early-stage companies.

FCF (Free Cashflow)

As we have talked about many statement from ‘Financials’ above, FCF is one metric that can be used to calculated Enterprise value.

Finance – Cashflow and Present Values

Free Cashflow is basically a measure of net inflows/outflows of cash once profit (ie. EBIT), taxes, capital expenditures, working capital, and depreciation/amortization are taken into account (ie. the net cash flows of a business).

From there, with a somewhat rudimentary model (example below), you can estimate the Discount Rate and calculate the value of the business looking into the future (the expected value of Future Cashflow). In other words, it is one way to estimate the valuation for a given business.

Finance – Cashflow and Present Value

Investors are always looking at businesses in different ways and trying to assess valuation from different angels (ie. multiples based on Revenue, EBITDA, etc). Without discussing the in-depth details here, FCF are used in DCF (Discounted Cashflow Models) to estimate future Enterprise Valuation for many companies.

WACC (Weighted-Average Cost of Capital)

When thinking about raising money, many people wrongly assume that raising equity is ‘free’ compared to debt (as there is on interest rate).

Because many firms have a mix of debt and equity on their balance sheet, WACC is a (somewhat complex) formula to calculate the average cost of capital between equity and debt.

Conceptually, it is important to understand this concept, as there are times strategically when equity makes more sense, and there are times strategically when debt makes more sense. Debt markets for early-stage companies are evolving rapidly, thanks to new revenue-based financing options as one example.

Equity (Market Capitalization)

Equity is representative of shares that investors typically buy into a company. The Market Capitalization of a company is typically calculated by multiplying the price per share X the number of shares outstanding.

For public companies, where shares are traded actively on public markets, the Market Cap. is displayed on any website with financial data. For private companies, a price per share needs to be calculated by a 3rd party (valuator) or agreed up between founders and investors.

At any moment, a company can issue new shares to investors; but issuing too many shares will cause dilution and can cause the shares of other investors to lose value.

Debt (Enterprise Value)

Debt can be issued to any company by a bank, shareholder group, investor, or other entity.

These types of loans can be structured in an array of different ways, but typically come with a specific interest rate (ie. 10%), term (5 years), and certain covenants that are secured against assets in the business (ie. contractual metrics that if breached require the loan to be repaid).

When we talk about Market Cap above, that is only based on equity valuation. Enterprise Value takes into account debt.

EV (Enterprise Value) = Market Capitalization – Market Value of Debt + Cash & Cash Equivalents

Convertible (Debenture)

Convertible Debentures are a somewhat common financial instrument in early-stage financing agreements, where they function as debt until a certain threshold is reached and then convert into equity.

The reason many founders will use them in early-stage companies with a lot of potential upside is because they have flexibility on valuation and are typically unsecured in early-stage companies, meaning investors will not require the security of personal assets in the event that the business fails to raise equity or pay back the outstanding loan amount.

They usually consist of:

>a trigger – normally raising a certain amount of equity capital above a certain valuation, at which point the debt automatically rolls into equity

>a valuation cap and floor – certain bands to ensure that there is a min. and max. price that the debt will be converted into equity

>a discount rate – a percentage discount that Convertible equity converts versus future investors. This includes the debt + interest payments, as is typically ~20% (ie. the Convertible investors will get a 20% better valuation than the next investors)

>a maturation date – whereby if the debt is not converted into equity (it isn’t triggered) it expires like any other debt

>an interest rate – whereby Convertible investors are paid interest for the duration of the Convertible up until either it is converted to equity or it expires

Let’s take a situation where a startup sold $100,000 of convertible notes with no discount, interest at 8 percent, and a valuation cap of $5 million that automatically converts upon a qualified financing of at least $1 million. Six months after the notes are issued the startup sells $2 million in Series Seed Preferred Stock on a pre-money valuation of $8 million.

Example of a Convertible

SAFE (Simple Agreement for Future Equity)

A SAFE is a more streamlined version of a Convertible and is absent of any debt. Like a Convertible, it has a valuation cap and floor, but without any necessity to pay interest or repay a loan. It is considered a ‘founder-friendly’ method of fundraising that has become particularly popular in startup hubs.

One of the main advantages of it is the removal of complex legal paperwork, it is usually a one-pager in essence.

SAFEs are used by early-stage startups because they delay the difficult task of figuring out how much a startup is worth. It is also a much cheaper and simpler contract than priced equity rounds, which may require months of negotiation and upwards of 30 pages of legalese costing tens of thousands of dollars.

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February 28, 2021 BMi