Lecture 11 Financial modeling of a Start-up Business

Feb 17, 2011

Financial Modeling

• How do you model a future set of events of which you know little?

• Why would you model such events?

• Who would believe it if you did?

Why do it?– Plans for the future

• Have you forgotten anything?– Creates debate

• No one right answer– Isolates assumptions for testing – Self-Consistency

• Look for inconsistencies– Sensitivity Analysis

• What’s important?/what’s not?• Informs management focus

– Drives funding events

Hockey StickRevenue$$

TimeNow

What’s wrong with this picture?

What’s wrong with this picture?

What’s wrong with this picture?

• requires lots of money• earlier revenue is much more desirable • low credibility• Hard to value• How long will the flat section last• Bored with seeing it. Very common• Leave out how high it is going to go

Can I improve it?Hard• If Biotech or some other product that requires

government certification• If product is still in the lab requiring development• If the market is not ready for the product• If the product requires enormous investment• Breaking into an established market• Spike in the cost of inputs• Macroeconomic Factors• Other?

Sharpen your pencil• Consider every line item of expense with the

question – How can I eliminate it?– How can I reduce it?– How can I delay paying it?

• Consider the times to bring money into the enterprise with the question– How can I reduce them?

• Consider the revenues that are earned with the question– How can I increase them?

Can I improve it?How to improve • Think of some short term product that can earn money quickly• License• Get DARPA or other government funding• Mixed Consulting/Product development model• Technology so incredibly compelling that can get “patient

money”*• Get larger investment to speed up

Assume Angel/VC Funding of $5M

0

10

20

$M

T years1 2 3 4 50

Is this a viable investment?

Assume Angel/VC Funding of $5M

0

10

20

$M

T years1 2 3 4 50

Is this a viable investment?More likely a “lifestyle business- not an Angel candidate

Assume Angel/VC Funding of $5M

0

50

100

$M

T years1 2 3 4 50

Is this a viable investment?

So let’s say that this is a good investment. . .

0

50

100

$M

T years1 2 3 4 50

Is this not a good place to start?

0

50

100

$M

T years1 2 3 4 50

Consider number of productsConsider number of markets

So we have the “answer”Can we make it real?

0

50

100

$M

T years1 2 3 4 50

Assume n=3

So we have the “answer”Can we make it real?

Product 1

Product 2

Product 3

• What assumptions can we make? (keep track!)• What must we consider now in our model?• What are the risks? (and how would you abate

them)

Let’s assume that this “answer” is not too ridiculous

Consider revenue side first

• Start with time • What is the sales cycle?

– Amount of time to make sale– How can you accelerate? Consider distribution modes– What is the price of your product?– How many can you sell? In what period of time?– Can you increase the number of business models to earn

revenue?– How do you phase your product introduction?

accelerate

• Publications• Third party validation• Competition• Refer to waldo• Advertising• Free trials• Partner with complementary companies

MonthSales Volume

Avg. Price Total Sales $

Jan-11 50 100

Feb-11     -

Mar-11     -

Apr-11     -

May-11     -

Jun-11     -

Jul-11     -

Aug-11     -

Sep-11     -

Oct-11     -

Nov-11     -

Dec-11     -

Consider now costsSGA• People

– Marketing– Sales– Technology

• Accounting• Equipment• Office Rent and expenses• Materials for product• Legal

– Incorporate or partnerships– Patent– Capital– Employment– Contracts

What is COGS?

• Cost of Goods Sold is the direct cost to make and sell product.– Direct labor (hours X rate)– Purchased materials used in product

Month Revenue - COGS = Gross marginJan-11     -

Feb-11     -

Mar-11     -

Apr-11     -

May-11     -

Jun-11     -

Jul-11     -

Aug-11     -

Sep-11     -

Oct-11     -

Nov-11     -

Dec-11     -

Selling General and Administrative Expenses (SGA)

• Payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees)

• Advertising expenses• Other

SG&A

Month Salaries Rent Leases Other TotalJan-11 $0

Feb-11 0

Mar-11 0

Apr-11 0

May-11 0

Jun-11 0

Jul-11 0

Aug-11 0

Sep-11 0

Oct-11 0

0

Capital costs

• Equipment• Computers

- Lease as much as you can!Add to monthly expenses

HW for next week

1. Sales (cf Collins Lecture) – What is your channel strategy for selling? – Why did you choose this strategy?

2. Begin Financial modeling– Model your first year expenses– When in the course of the company (which year

and quarter) do you think you will have First Revenue?

3. Update on marketing

R&D

• Costs of developing new products– Salaries– Equipment– Licenses– Consulting– Etc

• Many businesses are all R&D in the beginning

What should I put down for salary?

• As low as possible– Sweat equity- give shares of company instead of

salaries– Salaries should be below market but people have

to live- extended graduate student standard of living?

– Officers set example– Add ~30% for overhead– Consider barter

What should I put down for rent?

• Consider business technology centers• Consider garage• Consider lower income neighborhoods• Consider subletting from people with excess

space • Consider friends• Consider temporary places• Consider “virtual” location

Cash

• Need something to get started• Calculate burn rate. Add all expenses that you

must pay each month. Calculate time until you next need money. Start looking well in advance

• Typical funding is done in lumps with milestone triggering of the next tranch

Cash

Round A Round B

Loan

Sales kick in+$

-$

Time

RuleIn start-up, Cash =

This then is all you need for a first iteration

Now check• Make sure that

– You have captured all your assumptions and examined for reasonableness and sensitivity

– Attack the most important assumptions as early as you can. Capture them in your funding plan

– Your sales growth is reasonable – Your expenses are reasonable– Your time to revenue is reasonable– The numbers are internally consistent– Three significant figures tops!

Release of MoniesRound A

Round BLoan

Sales kick in+$

-$

Time

Assumption 1,2 proven Assumption 3,4 proven

Example of assumptions

Example of assumptions (triggering events)

One approach to look for sensitivity

0

50

100

$M

T (years)1 2 3 4 50

Aggressive case

Normal case

Conservative case

“Normally good to appear conservative”

As you get new data

• Iterate the financial model- this is a living document

How do you trade-off ownership for capitalization

• Before funding, you owe 100% of the company • Assume you would like to raise money. How do you calculate who owns what after the money is raised?

Ownershipbefore

Ownershipafter

Pre-money 2M where does this come from?

100% 67%

AngelInvestment

1.0M 33%

Post Money 3.0M 100%

A round

Pre-money 2M (how is this determined?)Angel invest 1M (Why this amount?)Total 3M (Valuation after A Round)Congratulations (?)

1. You have lost 1/3 of your company. 2. You have added strangers to your Board. 3. Well, at least you have majority ownership4. Your company is worth 3M of which your share is 2M. This is the best measure of a companies worth. What are others?

How much do I need?

• Usually more than you think– Time=money– Excessive optimism

• Market development• Hire people• Murphy’s Law

– Leverage all sources– Never stop– Allow 6 months + to raise money

I need more money to grow (or to survive)

B RoundPre-money 10M (how is this determined?)VC invest 5M (Why this amount?)Total 15M (Valuation after B Round)Congratulations (?)

1. Your company is now worth 15m 2. You have added new strangers to your Board. 3. How much do you own?

Ownership after B round• You own (66%) (10M) (66%)= 44%• Angels own (33%) (10M) (66%)= 22%• VC owns (33%) 15M = 33%

Bad news: You’ve lost control!Good news: Your investment is now

(44%)(15M) =6.6M (Up round. What is the alternative?)

Bad News: This investment is illiquid, i.e. there is no market to convert to cash