Lecture 11 Financial modeling of a Start-up Business

1. Lecture 11 Financial modeling of a Start-up Business Feb 17, 2011

2. 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?

3. 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

4. Hockey Stick Revenue $$ Time Now What’s wrong with this picture?

5. What’s wrong with this picture?

6. 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

7. 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?

8. 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?

9. 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

10. $M 20 10 0 1 0 2 3 4 5 T years Assume Angel/VC Funding of $5M Is this a viable investment?

11. $M 20 10 0 1 0 2 3 4 5 T years Assume Angel/VC Funding of $5M Is this a viable investment? More likely a “lifestyle business - not an Angel candidate

12. $M 100 50 0 1 0 2 3 4 5 T years Assume Angel/VC Funding of $5M Is this a viable investment?

13. $M 100 50 0 1 0 2 3 4 5 T years So let’s say that this is a good investment. . . Is this not a good place to start?

14. $M 100 50 0 1 0 2 3 4 5 T years So we have the “answer”Can we make it real? Consider number of products Consider number of markets

15. So we have the “answer”Can we make it real? $M 100 Product 3 50 Product 2 Product 1 0 1 0 2 3 4 5 T years Assume n=3

16. Let’s assume that this “answer” is not too ridiculous • 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)

17. 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?

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

20. 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

21. 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

23. Selling General and Administrative Expenses (SGA) • Payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees) • Advertising expenses • Other

24. SG&A

25. Capital costs • Equipment • Computers - Lease as much as you can! Add to monthly expenses

26. HW for next week • Sales (cf Collins Lecture) • What is your channel strategy for selling? • Why did you choose this strategy? • 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? • Update on marketing

27. R&D • Costs of developing new products • Salaries • Equipment • Licenses • Consulting • Etc • Many businesses are all R&D in the beginning

28. 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

29. 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

30. 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

31. Cash Loan Round A Round B +$ Sales kick in Time -$ Rule In start-up, Cash =

32. 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!

33. Release of Monies Round A Loan Round B +$ Sales kick in Time -$ Assumption 1,2 proven Assumption 3,4 proven Example of assumptions

34. Example of assumptions (triggering events)

35. $M 100 50 0 1 0 2 3 4 5 T (years) One approach to look for sensitivity Aggressive case Normal case Conservative case “Normally good to appear conservative”

36. As you get new data • Iterate the financial model- this is a living document

37. 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?

38. 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 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?

39. 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

40. I need more money to grow (or to survive) B Round Pre-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?

41. 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