Can You Pay Back Your Initial Investment Quickly? If So, You Have a Very Strong New Product.
By James F. Riordan
When considering a new product, it's important to figure its probable payback period. The payback period is the length of time it takes to get back the initial investment cost in a new product. Winning products are those which have the potential to pay back their initial investment out of the profits from the first production run.
In order to determine the payback period, you must first estimate:
1. The total investment in dollars2. The annual net profit of the project
Net profit or terminal wealth, is the amount of money you have left after paying:
1. Variable Costs--Costs which are constant per unit but vary in total depending on the level of output. IE: The cost of materials and components.
2. Fixed Costs--Costs which do not vary substantially with respect to output. IE: Plant and equipment costs, labor, etc.
3. Taxes, licenses, etc.
The annual net profit can then be calculated as follows:
Gross annual revenue (total income) - minus variable costs, fixed costs and taxes = Annual Net Profit.
Payback period is then calculated as follows:
Initial investment divided by annual net profit = payback period.
Short payback periods generally present less risk for the new product developer and the investor. While the payback period calculation is somewhat simplistic and does not consider all factors, it is a useful tool, especially in the early stages of development when a comprehensive financial analysis may not be possible or available.
The payback period does not measure profitability, nor should it be confused with the "investor participation period" which includes both the payback phase and the profit phase for the investor. Investors may not be as excited about determining payback period as the product developer, since payback means only that the investor has gotten back to "ground zero."
Typically, venture capital league investors have an "annual compound rate of return" figure in mind when they invest in a project and they assume they will get their initial investment back or they wouldn't do the deal in the first place. Bankers will be much more likely to want to see initial "payback period" calculations than venture groups. Essentially bankers are the pessimists. They look at how they can minimize the downside or worst case on an investment. A true venture capitalist is the optimist who looks for the maximum upside or best case.
You can be sure that both types of investors look at one key issue regarding payback period--the projected product life cycle had better well exceed the payback period.
Payback period can be shortened significantly by good planning on the part of the new product developer. At the earliest stages in development, developers must decide whether to sell, license, or cross-license the product or technology to another party or whether to manufacture and market the product themselves. As soon as this question is answered, the prudent developer begins to compile a list of target companies which may be interested in buying or licensing the patent rights, or plots out distribution channels and compiles a list of potential distributors, depending on which option was chosen. If the developer is undecided on which path to choose, BOTH lists should be compiled. By compiling these lists in the earliest stages of product development, there will be less time lag in getting the product to market after the research and development is completed, and the payback period will be shorter.
Payback period can be lengthened considerably by bad debt or slow paying, deadbeat customers. Prudent developers who plan to sell their products themselves should be sure to do THOROUGH credit checks before shipping product to buyers. When you are dealing with small stores, this can be as simple as checking with their bank to see how long they have had their account and what the approximate balance is. With large orders for large companies, it may entail a Dunn & Bradstreet report, a review of their current balance sheet, a full-blown audit of their books, or the establishment of a performance guarantee bond, depending on the size and dollar volume of the order.
The developer should make arrangements IN ADVANCE OF SALES with a collection agency, to be sure bad debt does not become a problem and lengthen an otherwise acceptable payback period. Usually, bad debt (money that is owed but is uncollectible because the buyers went bankrupt or simply wont' pay, etc) amounts to about two percent of gross sales per year, and can go as high as four percent on a nationwide average.
On giftware products which I sold to "Mom and Pop" gift stores, I ran as high as a 12 percent loss in New York City, where people start businesses, order product from everybody on credit, sell the product, then close the doors, pay nobody, bankrupt the business and then open a new store across the street and do it all over again.
In order to cut my losses, I started using Transworld Systems collection agency, and I was very happy with the results. They charged me a fair (and fixed) price-per-deadbeat, which quickly cut my losses to less than one percent.
Regardless of which agency you choose to use, you must have one available. Remember that the product is not really sold until the money is in your hand, and the longer that takes, the longer your payback period will become.
The above article was taken from James F. Riordan's classic book, HOW TO EVALUATE THE POTENTIAL FOR SUCCESS OF A NEW PRODUCT OR TECHNOLOGY. Riordan's highly-acclaimed, 36-point system is a valuable tool for inventors, product evaluators or anyone interested in the invention process. Each section is followed by a comprehensive questionnaire that can be used to evaluate your product.
The highly-recommended book can be ordered through the Dream Merchant, 2309 Torrance Blvd., Suite 104, Torrance, CA 90501. The phone number is (310) 328-1925.
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