Financial Projections
For Start-ups
Thomas Hellmann © 2014
Objectives
• Give investors what they ask for?
– Yes, but why do they want it?
• Determine profitability of venture?
– Impossible to predict future accurately
– FP input for current valuation and/or future exit value
• Assess viability of venture?
– What assumptions required for venture to be feasible?
– Breakeven analysis
– Scenario analysis
Objectives (continued)
• Determine financial needs?
–
–
–
–
How much funding is required?
For what?
When do I need it?
How long will it last?
• Develop deeper understanding of business?
–
–
–
–
FP reflect entrepreneur’s perspective on industry
Comparison with industry averages revealing
Define operating metrics and business milestones
Scenario analysis (again)
• FP spreadsheets not suitable as an accounting system
REVENUE
PROJECTIONS
Revenue Projections
• Revenues = Price * Volume
• Price determination
– Strategy
– Competitive forces
– Industry price dynamics
• Four approaches for estimating volume
–
–
–
–
Top-down
Bottom-up
Copy-cat
More-of-the-same
• In practice, use combination
– E.g. Top-down for where you are going (5 years ahead) but bottom-up
for where you are (year 1)
Top down revenue projections
Top down revenue projections
• Define relevant market segment
– Detailed segmentation key
• Existing markets:
– Look up current market revenues
– Project market growth rate
– Estimate obtainable market share
• (Hopefully) Emerging markets:
– Estimate potential market size
– Estimate market adoption curve (S-curve)
– Estimate obtainable market share
• Classical mistakes:
– “Everybody in China will buy our product”
– “We only need 1% of a $1Billion market”
Top down revenue projections
Recipe:
Use two pounds of fresh primary market research
Mix in a cup of secondary market data
Lightly sprinkle some theoretical reasoning
Decorate subtly with wishful thinking
Serve hot
The S curve
Revenues
Time
Bottom-up revenue projections
Bottom-up revenue projections
• Basic idea:
–
–
–
–
Define basic unit of product / service
Estimate customers purchasing units
Multiply by average price
Estimate customer growth over time
• Focuses on ability to deliver
•
Assumes customers available
• Top-down focused outside & demand driven
• Bottom-up is focused inside & supply driven
• Combination of top-down and bottom more powerful
Copy-Cats and More-of-the-same
Copy-Cats and More-of-the-same
• Industry comparables
• Competitor comparables
• For established businesses, use recent growth rates
• Obvious caveat: past performance is not a reliable indicator of
future performance
• Better fundamental: Industry or firm S-curve
REVENUES AND
CHANNEL
STRATEGY
Revenues and costs in a value chain
Supplier
costs = $2
Production
costs
(COGS) =
$5
Price to
distributor
= $9
Price to
retailer =
$15
Average
discounted
retail price
= $24
Suggested
retail price
= $30
Revenue
List Price
Source: Mark Leslie, Stanford GSB
Profit + SG&A +
R&D
List Price
Reseller
16
End Consumer
Cost of Goods
(Supply Chain)
Revenue
EU
Discounts
Distributor/Reseller Channel
Reseller
Discounts
Profit + SG&A + R&D
Distributor
Cost of Goods
(Supply Chain)
EU
Reseller Channel
End Consumer
Channel Economics
Classroom Exercise
• Identify two concrete channels (direct or indirect) of how
to reach a customer, and then ask them to map out:
• What type of final customer is reached with that channel?
• What is the unit of goods sold?
• What is the average price paid by the customers?
• What is the average price received by the company?
• Are there different prices for different customers?
• How much revenue do you expect for each channel
– Focus on the first year!
– We will not ask them about costs now!
• Based on this analysis, which channel should you pursue?
COST
PROJECTIONS
19
Cost projections
• Variable costs – Cost of goods sold
– Typically expressed as % of sales, but...
– Scale economies: Decreasing unit COGS due to efficiencies, volume discounts
– Scale economies: Increasing unit COGS due to capacity / shortages / quality
problems, etc...
• Fixed costs – Operating expenses
– Employees, Rent, PP&E, Overhead, R&D, Marketing and sales, etc...
– At low levels of production think of them purely as fixed costs
– At high levels, operating expenses tend to grow with production
– E.g. Need second facility
• Estimation methods
– Direct cost estimates:
• Supplier-based
• Expert-based
– Copy-cat industry / competitor cost ratios
– Are inputs outsourced or produced in-house?
Value chain & operating stacks
• Value chain diagram
• Operating cost stack
100%
15%
90%
10%
80%
70%
60%
Overhead
40%
15%
30%
20%
M&S
R&D
50%
40%
Net earnings
20%
10%
0%
% of revenues
COGS
Development cost projections
• Business set-up costs
– Legal, Licenses, Office space, Basics
• Develop research plan
– Timed activity plan
– Define priorities
• Estimate research costs
– Employees
– Equipment
– Licensing in technology
• Define milestones
– Define demonstrable progress markers
• Prototype, Beta customers, etc…
– Milestones be used for financial contracting
• Planning of grants
– Preference for non-dilutive funding!
Budget for founder salaries?
• Before outside financing, founder salaries largely meaningless
• Outside investors not too fond of paying high salaries in early
stages
• Founders need to set expectations that one day they want to
eat something better than Ramen soup!
– Write employment agreement
– Define founder salary
– Take reduced salary for initial years
INTEGRATED
PROJECTIONS
Useful links
• Stanford Technology Venture Formation
http://www.stanford.edu/class/msande273/resources.html
– Peter Kent’s financial model (too complex)
– Jeff Kuhn’s model (too simple)
– Jeff Kuhn’s video on understanding balance sheets and income
statements (probably unnecessary for MBAs)
• Hellmann Model
http://strategy.sauder.ubc.ca/hellmann/
– Goldilocks says: (Just right)
• WWW
– Lots of models freely available
Fundamental versus Pro Forma
• Fundamental projections:
– Development schedule (aka investments)
– Revenues
– Costs
• Pro Forma statements:
– Income Statement (a.k.a. Profit and loss statement)
• Establish viability & profitability
– Cash flow statement
• Determine financial needs
• Monitor survival
– Balance sheet
How long, how often, how detailed?
• Length
– Minimum 1-2 years; typical 3-5 years; maximum ???
– Depends on industry and development cycle
• Retail: a few months
• Software: a few years
• Biotech / Cleantech: a few decades
• Frequency
– Monthly: “only the paranoid survive”
– Quarterly: “balanced approach”; still captures seasonality
– Yearly: “big picture”
• Detail
– I n a presentation only shows highlights
• Revenue projections
• Investment / Costs highlights
• Income / cash flows (“The ubiquitous hockey stick”)
– Be ready for justifying each number!
PRESENTATION
EXAMPLE #1
Financial Projection
$120
$100
$80
$Millions
$60
$40
$20
$0
-$20
2012
2013
2014
2015
2016
Total Revenue
$8,800
$132,800
$864,000
$21,160,000
$99,550,000
Gross Margin
($18,939)
($175,748)
($48,167)
$9,971,397
$48,566,526
Total Operating Expenses
$2,642,643
$6,339,171
$12,303,334
$21,733,046
$43,654,877
Income Before Int & Taxes
($2,661,581)
($6,514,919)
($12,351,500)
($11,761,650)
$4,911,649
Operating Stacks
84%
15%
PRESENTATION
EXAMPLE #2
Financials: Business Model
Unit economics
Annual Recurring
Sale Price: $3250
Premium Package: $500
Unit Cost: $1700
Annual Costs:
- Goggles / Sensor $950
- Extended Warranty
- Gloves $400
- Live Tech Support
- Accelerometer $350
- Training Website
Unit Gross Margin: 40%
Financial Model: Assumptions
Product per Customer
Uptake of Premium Package
Target Market Entry Share
Growth Rate
Inventory
Salary
•1
• 50%
• 2%
• 2% + 1%n years
• 10% Annual Sales
• +5% Annual
Software Updates
• Quarterly
Product Iterations
• Every 2 years
Profit and Loss
$MM
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Unit Sales
0
9
862
1679
2934
5478
Head Count
5
5
8
13
15
21
Revenue
0
0.03
2.9
6.0
10.7
20.1
Gross Profit
0
0.02
1.5
3.2
5.7
10.7
Gross
Margin %
49
49
49
50
51
51
Operating
Expenses
0.8
0.7
1.5
1.9
2.5
3.8
EBITDA
-0.8
-0.7
0
1.2
3.2
6.9
Net Income
-0.8
-0.7
0
0.9
2.2
4.9
Revenue and Net Income
Payback
X
Break-Even
Point
X
Seed Round 1
X
X
Operating Stacks
PRESENTATION
EXAMPLE #3
Millions
Revenue & Market Penetration
$160
$152
100%
90%
$140
80%
$116
$120
70%
$100
60%
$76
$80
50%
40%
$60
$41
$40
30% 30%
23%
20%
15%
$20
10%
8%
$-
0%
2013
2014
2015
Revenue
2016
2017
Market Penetration
2018
2019
Go to Market
2013
Sales
Alpha
customer
Head
Count
13
Hardware
First release
Software
Mouse,
keyboard
2014
2015
Distributor
Phase I
Beta
customer
31
Shrink
final
2017
Distributor Phase II
67
Rev 2
PACS specific
2016
102
139
Ongoing development
2 PACS/year
Assumptions
25% of all
operations
• 50%-75% of operations use imaging.
• Half of those are long enough.
33% Distributor
Markup
• Retail price of $112.50
• Wholesale price of $75.00
Slow Medical
Market
• 15% penetration in 5 years
• 30% penetration in 7 years
Class I Device
• No FDA approval
• 90 day pre-market notification
Steady Adoption
• Growth rate is linear
Millions
Financial Projections
$160
$140
$120
$100
$80
$60
$40
$20
$-$20
$3.4
-$1.4
2013
-$4.1
2014
Revenue
-$8.6
2015
$9.6
$16.2
-$0.8
2016
Gross Profit
2017
EBITDA
2018
2019
Operating Stacks
100%
26%
14%
18%
80%
16%
60%
14%
28%
45%
40%
15%
18%
18%
30%
22%
22%
21%
25%
26%
35%
35%
34%
40%
20%
0%
2013
R&D
2014
Sales/Marketing
2015
Operations
2016
2017
General & Administrative
Funding Milestones
2013
Cash Reserve
Q1
Q2
Q3
2014
Q4
Q2
13
Hardware
First release
Software
Mouse, keyboard
Alpha
customer
Q3
Q4
Q1
Q2
Q3
31
67
Shrink
final
Beta
customer
2017
2016
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Series C
$8.5 MM
Series B
$5 MM
Series A
$1.5 MM
Head
Count
Sales
Q1
2015
Rev 2
PACS specific
Distributor Phase I
102
139
Ongoing development
2 PACS/year
Distributor Phase II
Q4
CONCLUDING
THOUGHTS
Key insights from pro forma statements
• Income statement
– Hockey stick for earnings (EBITDA, EBIT, Net earnings)
– Show good earning at some future point
– Breakeven analysis
• Cash flow statement
– Initial financing needs
– Future financing needs (staged financing)
– Time when company becomes cash flow positive
• Balance sheet
– Determine asset intensity
– Financial health
Classic mistakes (I)
• Revenues
– Overestimate speed of revenues
– Unjustifiable revenue spurts
– Missing costs of generating sales
– Distinguish listed and actual average price
• Cost
– Forget costs of running business
– Plan for underutilization
• both revenues % costs)
– Full labor costs
• including benefits, training, bonuses, etc…
Classic mistakes (II)
• Cash flows
– Late payments and collection costs
– Underestimate true cost of trade credit
– Time to raise funding
• Overall
– Ignore industry ratios
– False precision
– Level of detail
• internal operations vs. external presentation
– Mismatch between financials and business plan
Final words of wisdom
Cash flows
are more important
than your mommy!