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 Stick Revenue $$ Time Now 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 $M T years Is this a viable investment?

Assume Angel/VC Funding of $5M $M T years Is this a viable investment? More likely a “lifestyle business - not an Angel candidate

Assume Angel/VC Funding of $5M $M T years Is this a viable investment?

So let’s say that this is a good investment $M T years Is this not a good place to start?

$M T years Consider number of products Consider number of markets So we have the “answer” Can we make it real?

$M T years 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

Month Sales Volume Avg. PriceTotal Sales $ Jan Feb-11 - Mar-11 - Apr-11 - May-11 - Jun-11 - Jul-11 - Aug-11 - Sep-11 - Oct-11 - Nov-11 - Dec-11 -

Consider now costs SGA 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 margin Jan-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 MonthSalariesRentLeasesOtherTotal Jan-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

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 ARound B Loan Sales kick in +$ -$ Time Rule In 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 Monies Round A Round BLoan Sales kick in +$ -$ Time Assumption 1,2 provenAssumption 3,4 proven Example of assumptions

Example of assumptions (triggering events)

One approach to look for sensitivity $M T (years) 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? Ownership before Ownership after Pre-money2M where does this come from? 100%67% Angel Investment 1.0M33% Post Money3.0M100%

A round Pre-money2M (how is this determined?) Angel invest1M (Why this amount?) Total3M (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 ownership 4. 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 Round Pre-money10M (how is this determined?) VC invest5M (Why this amount?) Total15M (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