New Venture Development Exam 2 content Spring 2013

Working Capital Working capital consists of the current assets and the current liabilities of a business. Current assets are gross working capital. – Cash, marketable securities, accounts receivable, and inventory Net working capital is the difference between a business’s total current assets and its total current liabilities.

Working Capital Management Working capital management is our ability to effectively and efficiently control current assets and current liabilities in a manner that will provide our firm with maximum return on its assets and will minimize payments for its liabilities.

Current Asset Management Cash management Marketable securities management Accounts receivable management Inventory management

Cash Management The goal of cash management is to obtain the highest return possible on cash. Cash consists of: – Petty cash – Cash on hand – Cash in bank, checking – Cash in bank, savings

Marketable Securities Management Marketable securities normally are those investment vehicles that include U.S. treasury bills, government and corporate bonds, and stocks. Excess cash should be placed in the above vehicles because they increase in value more than cash itself.

Accounts Receivable Management The goal of accounts receivable management is to increase sales by offering credit to customers. – Options to offering credit include: The business issuing its own credit card or line of credit. Factoring—selling accounts receivable to another firm at a discount off of the original sales price.

Accounts Receivable Management (continued) The 3 C’s of credit: – A customer’s character is favorable if that customer has paid his or her bills on time in the past and has favorable credit references from other creditors. – Capacity to pay refers to whether the customer has enough cash flow or disposable income to pay back a loan or pay off a bill. – Collateral is the ability to satisfy a debt or pay a creditor by selling assets for cash.

Accounts Receivable Management (continued) Credit terms are the requirements that our business establishes for payment of a loan (the use of credit by a customer). – To speed up collections, cash discounts are often offered to a business customer. An example would be 2/10 net 30. If the customer pays the bill within 10 days of the invoice a 2 percent discount is given. Otherwise the entire net is due 20 days later or at the 30th day.

Accounts Receivable Management (continued) Analyzing accounts receivable: – Accounts receivable turnover: – Example: – Collection days is 365 days in a year divided by accounts receivable turnover:

Use of collection days: – If collection days exceed our credit terms, then we have to speed up collections. Example: If we give terms of 30 days and we collect in 61 days as previously shown, then we have to speed up collections in order to better manage accounts receivable. We may also have to re- evaluate our credit policies. – If collection days are less then our terms, then we have increased our liquidity. May also consider loosening credit policy. Accounts Receivable Management (continued)

Aging of accounts receivable is accomplished by determining the amounts of accounts receivable, the various lengths of time for which these accounts have been due, and the percentage of accounts that falls within each time frame. Related: See Joe D. Plummer forecasting and budgeting Accounts Receivable Management (continued)

Customer Outstanding BalanceDays Outstanding < 30< 60<90> 90 1 $ 5, , , , , , , , , , Total $ 100,000 $ 10,000 $ 35,000 $ 29,000 $ 25,000 Aging of accounts receivable Weighted average days outstanding = 64.9 days

Apple’s Current Asset Management

Inventory Management The overall goal of inventory management is to minimize total inventory costs while maximizing customer satisfaction. Two primary decisions must be made: – Establish the reorder quantity (the number of items to order) – Establish the reorder point (that level of inventory at which a new order will be placed).

Economic Order Quantity Formula: – Attempts to balance ordering costs against storage costs and provide us with the most economic quantity to order to minimize overall inventory costs. – Where Inventory Management (continued)

EOQ and Quantity Discounts – If the business is large or uses items in quantity, then quantity discounts may override the EOQ formula. We will determine this by use of both the EOQ formula previously given and the total cost formula which is:

Inventory Management (continued) – Determining EOQ with quantity discounts requires the following procedures: Compute EOQ for each discounted price. If the computed EOQ falls within the discounted quantity area, then order the EOQ. If the EOQ does not fall within the discounted quantity area, then compute total inventory costs. Order the minimum quantity that provides the lowest overall total inventory costs.

Inventory Management (continued) Reorder Point Calculations – The reorder point (ROP) has three factors that are used in determining the quantity of an item that exists when we actually place an order: Lead-time (L) is the time that lapses from order placement to order receipt. Daily demand (d) is the quantity of a product that is used per day. Safety Stock (ss) the quantity of stock you keep for variations in demand.

Current Liabilities Management Current liabilities management consists of minimizing our obligations and payments for short-term debt, accrued liabilities, and accounts payable. It consists of: – Short-term debt management – Accrued liabilities management (servicing long- term debt) – Accounts payable management

Current Liabilities Management (continued) Short-term debt management – Short-term debt consists of business obligations that will be paid within the current accounting period. They consist of the following: Current payments on long-term debt Bank lines of credit Notes payable Accounts payable Short-term loan for one year or less

Current Liabilities Management (continued) Lines of credit: – A line of credit is similar to a credit card. With it, we obtain a credit limit, but we are not obligated to make payments unless we actually borrow the money. A line of credit is normally obtained from our primary bank. A line of credit is used when our cash outflow exceeds our cash inflow.

Accrued Liabilities Management (continued) Accrued liabilities are those obligations of the firm that are accumulated during the normal course of business and are primarily payroll taxes and benefits, property taxes, and sales taxes.

Accounts Payable Management Accounts payable are the debts of a business which are owed to vendors. Vendors offer several types of discounts. They are: – Trade discounts – Cash discounts – Quantity discounts

Accounts Payable Management (continued) Trade discounts are amounts deducted from list prices of items when specific services are performed by the trade customer. – Trade discounts may be expressed as a single amount, such as 30 percent, or in a series, such as 30/20/10.

Accounts Payable Management (continued) Trade discount examples – 2/10 net 30 - buyer must pay within 30 days of the invoice date, but will receive a 2% discount if they pay within 10 days of the invoice date. – 3/7 EOM - buyer will receive a cash discount of 3% if the bill is paid within 7 days after the end of the month indicated on the invoice date. – 3/7 EOM net 30 - buyer must pay within 30 days of the invoice date, but will receive a 3% discount if they pay within 7 days after the end of the month indicated on the invoice date – 2/15 net 40 ROG - buyer must pay within 40 days of receipt of goods, but will receive a 2% discount if paid in 15 days of the invoice date. – Trade discounts may be expressed as a single amount, such as 30 percent, or in a series, such as 30/20/10.

Accounts Payable Management (continued) Cash discounts are offered to credit customers to entice them to pay promptly. – The seller views a cash discount as a sales discount. – The customer views it as a purchase discount. – The terms of a cash discount play an important role in determining how the invoice will be paid. “Preferred payment” method discount – Some retailers (particularly small retailers with low margins) offer discounts to customers paying with cash, to avoid paying fees on credit card transactions.

Accounts Payable Management (continued) Cash discounts will normally appear on an invoice in terms such as 2/10 n30. – This means that the customer may deduct 2 percent off of the invoice price if he or she pays within 10 days. – If the customer does not pay within 10 days, he has the use of 98% of the money owed for the next 20 days. – If the customer pays within 30 days, the net, or total amount, of the invoice is due. – If he or she pays after 30 days, the credit agreement with the seller normally stipulates that a monthly interest charge be added to the unpaid balance.

Accounts Payable Management (continued) Calculations used in cash discounts: – A $10,000 invoice with terms of 2/10 n30 – Option 1: Pay off the $10,000 with a payment of $9,800 within 10 days of the invoice date. This is computed by multiplying the invoice price by 1 minus the discount ( = 0.98, and $10,000 x 0.98 = $9,800). Or by taking the invoice price times the discount and subtracting it from the invoice price ($10,000 x 0.02 = $200, and $10,000 - $200 = $9,800).

Accounts Payable Management (continued) Calculations used in cash discounts (continued): – A $10,000 invoice with terms of 2/10 n30 – Option 2: Pay the invoice price of $10,000 on the 30th day after the invoice date. If this option is chosen, he will pay the equivalent of 36.7 percent annual interest because of his delaying payment. The logic is shown on the following page.

Accounts Payable Management (continued) Calculations used in cash discounts (continued): – $200 is the cost paid on $9,800 for 20 days, or an interest rate of 2.04 percent ([$200  $9,800] x 100). – This will result in an effective annual interest rate of 36.7 percent (2.04 x [360  20days]). – The effective annual interest rate is obtained by multiplying the time period interest rate by the number of time periods in an accounting year (360  20).

Accounts Payable Management (continued) Quantity discounts are offered by vendors to increase their own cash flow when they offer discounts to customers who purchase items in large quantities.

The working capital cycle A negative working capital cycle is a good thing; Owen must borrow $ to maintain WC

Trade discounts The offer Your supplier offers you a trade discount of 2/10n30 What does this mean? You get a 2% discount if you pay within 10 days Otherwise, pay full amount within 30 Implications But you are essentially borrowing $200 at an effective annual interest rate of 37%

Forecasting A forecast is a quantifiable estimate of future demand. Forecasting in business is the process of estimating the future demand for our products and services. Forecasting for the financial manager also requires estimates of future interest rates.

Practical Sales Forecasting for Startup Businesses Steps to take for a sales forecast: – Listing what you know: Expertise, experience, knowledge of charges and fees. Previous revenue and cost information based on experience. – Research similar companies via EDGAR competing company annual reports, or industry-specific publications. – List three types of expenses: Startup Fixed Variable – Develop a revenue forecast

Forecast of Revenue for a Startup - Autoshop

Pro Forma Financial Statements A pro forma financial statement is a projected statement based on the forecast. The three basic pro forma statements are: – Pro forma income statement – Pro forma cash budget – Pro forma balance sheet

Pro Forma Balance Sheet Using Percentage of Sales Percentage of sales method is based on the fact that assets and liabilities historically vary with sales. – Thus any increase in sales will cause a subsequent buildup in both assets and liabilities. – Both profit margins and dividend (owner) payout ratios determine the amount of internal financing that can be applied to support increased asset buildup. – See examples Chapter 6 Adelman & Marks and Vermont Teddy Bear Company Forecasting

Percentage of sales method – forecasting balance sheet

Financial Statements Income Statement Balance Sheet Statement Of Cash Flows

Building Integrated Financial Statements BUILDING YOUR PRO FORMA FINANCIAL STATEMENTS Build-up Method Comparable Method Final Steps

BUILD-UP METHOD Revenue Projections COGS Operating Expenses Revenue Worksheet COGS Worksheet Operating Expense Worksheet Preliminary Income Statement

COMPARABLE METHOD Choose industry metrics Compare your projections to other companies and industry average Benchmark other companies in the industry

BUILDING INTEGRATED FINANCIAL STATEMENTS INTEGRATED FINANCIAL STATEMENTS Income Statement Monthly forecasts for years 1 and 2 Adjust monthly forecasts according to seasonality Annual forecasts for years 3-5 Balance Sheet Consider Accounts Receivable Show outflow and depreciate PP&E Consider Accounts Payable Statement of Cash Flows

 Focus on major infusions of cash describe the nature of your  accounts receivables and payables  Mention PP&E expenses PUTTING IT ALL TOGETHER 2-3 page explanation of your Financial Spreadsheets  Talk about revenue drivers  Talk about seasonality  Discuss the expense categories  Focus on major infusions of cash  Describe the nature of your cash flows  Accounts receivables and payables  Mention PP&E expenses  Talk about major asset categories, and any Liabilities that aren’t clear from the previous discussion Discuss the Income Statement Discuss the Cash Flow Statement Discuss the Balance Sheet

Reduced survival chance Underestimating time to secure financing Top-down versus bottom-up forecasting Lack of comparables Underestimating time to generate revenues Underestimating costs Not understanding the revenue drivers Common mistakes entrepreneurs make

Joe D. Plummer budgeting 71% of Joe’s revs are on credit His COGS seems a bit high… He has substantial fixed costs Help him!

The Campaign to Raise Capital New venture financing

The campaign to raise capital The vast majority of funded deals using venture capital follow this course of events: 1.Set funding objectives 2.Prepare the plan to attract investors 3.Pick the best capital-raising strategy 4.Assign tasks 5.Launch the campaign 6.Make presentations 7.Incorporate feedback from presentations

Crown Semiconductor – A by-the-numbers approach to raising capital Hired a household-name veteran CEO Added 3 friends with strong industry experience from 2 seed VC firms – made them advisers to the board of directors Consistently presented start-up as “blue chip” of all companies in this new technology Used well-known law firm to get introductions to 5- 7 top VC sources

Crown Semiconductor – A by-the-numbers approach to raising capital Negotiated for $10M in first round, expected to get only $6M Set minimum ownership dilution point for owners at 30% by projected IPO time Gave up only one more board seat to investors in first round Presented an extremely focused sales pitch: “top CEO!” “5 months from shipping first product!” “You better get in now, because there is no tomorrow”

The Road Show Definition: a presentation by an issuer of securities to potential buyers The term “road show” applies to the presentations management gives to analysts, fund managers, and potential investors around the country when they want to issue securities or do an initial public offering (IPO) The road show is intended to generate excitement and interest in the issue or IPO, and is often critical to the success of the offering. Also known as a "dog and pony show."

1994: Netscape’s Road Show Netscape files to go public on June 23, 1994 Overwhelming reception on the road suggests a bubble psychology is taking over the investment community Instead of meeting with 3-4 analysts from a given institutional investor in each city, Netscape got at their presentations – most wanted to understand the Internet Investors didn’t want to miss “the next Microsoft”

The campaign to raise capital The vast majority of funded deals using venture capital follow this course of events (continued): 9.Modify plan but maintain vision 10.Due diligence 11.The lead VC says “We will invest!” 12.Closing the VC contract 13.Closing week 14.Cash in the bank

Chips and Technologies Financing

Chips and Technologies Equity Ownership

Conclusions Raising capital is a very time- and effort-intensive activity – it never ends for the start-up firm Professional management, experience, time until first sales, and attractive cash flows and ROI are essential There are many routes to the IPO – you can be creative with raising capital (see Chips and Technologies) or disciplined (Crown Semiconductor)

Bigfoot Networks 1.What is the business model presented in the business plan? Do you think it is viable? 2.Imagine you are an Angel investor who is going to be sitting in the audience during Bigfoot Networks business plan presentation in April of 2005: a)Would you be willing to offer to buy a $50,000 unit of the $200,000 being sought for the seed money investment? b)Assume you decide to invest. What concerns would you have and what due diligence would you perform to address them before writing the check?

Letter Logic valuation

2003 In 2003, LetterLogic has annual revenues of $2,500,000. They would like to grow their revenues to approximately 10x this value over the next several years. Despite the company's success with revenue generation, no banks or equipment suppliers would agree to provide the company with a line of credit. All the company had was founder Sherry Deutschmann's business credit card with a $5,000 limit. Later that year, she met a venture capitalist who offered to invest $350,000 in her company in exchange for an equity stake of 25%. Importantly, he also guaranteed a $500,000 line of credit. With this line of credit, Deutschmann was able to grow here business to annual revenues of $21,000,000 by Banks routinely contact her with offers to provide loans and new lines of credit. To understand the valuation exercise in the spreadsheet, we first have to examine how the initial VC investment affected the company's valuation. Getting 25% of a company for $350,000 means that the company was worth $1,400,000 ($350,000/0.25) 2011 In 2011 with annual revenues of $21,000,000, we know what the top of the income statement looks like, but not the new valuation. Using the same pre-money valuation ratio from 2003, a company that makes $2,500,000 and is worth $1.4M would hypothetically be worth around $11.8M in 2011 when it is making $21 M. ($1.4M X $21M/$2.5M). Another way to determine the value of LetterLogic in 2011 is to use market comparables. Deluxe Corporation had a net income to revenues ratio of 10.2% and a P/E ratio of Using this market comparable, the value of LetterLogic should be $21M X 10.2% X 8.67 = $ By logical extension, the value of the venture capitalist's investment of $350,000 in 2003 is now worth $4,642,792, which represents an internal rate of return of 1,227%! By providing the right financing for growth AND a line of credit for working capital needs, both the company and the venture capitalist realized high returns from this venture.

Proof Eyewear Do the math for the first year. $433,000 in total revenues brought $150,000 in profits. They have great gross profit margins (300% for wholesalers, 600% for retailers). The boys "don't take any salary." What's going on with operating expenses? The brothers think the company is worth $1.5 million. The Sharks think the company is worth $600,000. Who is right and why? (consult the revenue numbers and growth projections for your answer) How much does Kevin's demand for an up-front royalty payment affect Proof's ability to grow organically through revenues?