Financial Projections For Start‐ups For Start ups
Prof. Thomas Hellmann University of Oxford © 2014
• Magic mirror in my hand, Magic mirror in my hand who is the fairest in the land? • My queen, you are the f i fairest here so true. h • But Snow White has a B tS Whit h thousand times more thousand times more EBITDA than you. y
First Mirror Image First Mirror Image
Business B i Plan
FP reflect business strategies, t t i milestones milestones, scale and viability
Second Mirror Image Second Mirror Image
Learning L i about Self
Process of generating FP forces entrepreneurs to reflect on assumptions
Third Mirror Image Third Mirror Image
IImage to t Investors
FP reflect to in estors the investors prospects p business p and financial needs; also entrepreneurs’ entrepreneurs financial literacy and conceptual clarity
Limitations • Financial Projections are always wrong – Unpredictability of start‐ups – Timing hard to guess – Beware of false precision B ff l ii
• Financial Projections are always out of date – Good entrepreneurs change strategy often Good entrepreneurs change strategy often – Lean start‐ups ‘pivot’
• Financial Projections are always optimistic Financial Projections are always optimistic – Code language: “our projections very conservative” – Investors expect optimistic projections – Describe the ‘good case’, not the ‘average case’
• Financial Projections are not a substitute for proper financial accounting record keeping k
HOW TO HOW TO DEVELOP DEVELOP FINANCIAL FINANCIAL PROJECTIONS?
A Fine Recipe A Fine Recipe
Use two pounds of fresh primary market research Mi in Mix i a cup off secondary d market k data d Lightly sprinkle some theoretical reasoning Decorate subtly with wishful thinking Serve hot
Basic Steps Basic Steps • Project Revenues Project Revenues • Project all costs – Cost Cost of good sold, Expenses, Development costs, of good sold Expenses Development costs Taxes, etc…
• Build projections Build projections – Cash Flow Statement – Income Statement I St t t – Balance Sheet
• Present financial projections f l • Manage cash
REVENUE REVENUE PROJECTIONS
Revenues Revenues = Price * Volume P i *V l
Define counting unit Define counting unit • Define unit sale • Use ‘average’ transaction • Examples – – – – – – – –
Museum Restaurant Online newspaper O li Online video game id Nuclear power station F hi Fashion consultant lt t Military subcontractor Etc…
Estimating Prices Estimating Prices • Customer–centric – Value proposition – Willingness to pay – Customer segmentation
• Competitor‐based p – Cost‐quality comparison – Market dynamics Market dynamics – Initial pricing strategy
• Value‐chain constraints Value‐chain constraints Supplier costs = $2 t $2
Production costs (COGS) (COGS) = $5
Price to distributor d st buto = $9
Price to retailer = eta e $15
Average discounted retail price t il i = $24
Suggested retail price eta p ce = $30
Estimating Quantities Estimating Quantities • Four approaches h 1. 2. 3. 4.
Top‐down Bottom‐up Copy‐cat Copy cat More‐of‐the‐same
• In practice, use combination In practice use combination
The S curve The S curve Revenues
Time
Top down revenue projections Top down revenue projections
Top down revenue projections Top down revenue projections • Define relevant market segment g • 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 market adoption curve (S curve) – Estimate obtainable market share
• Classical mistakes: Classical mistakes: – “Everybody in China will buy our product” – “We only need 1% of a $1Billion market”
Example: Asia Renal Care p China Population (in mil) Treatment rate Incidence rate (in mil) People with ESRD Urban population Urban population Urban ESRD Insured Insured Urban ESRD Price per treatment Average yearly visits Annual revenue per patient Total market size Total market size
1199 19 629 754171 30 00% 30.00% 226251 30.00% 67875 $53 130 $6,890 $467 661 437 $467,661,437
Taiwan
China / Taiwan 21 57.10 630 630 13230 57.00 100 00% 100.00% 13230 17.10 100.00% 13230 5.13 $156 0.34 130 $20,280 0.34 $268 304 400 $268,304,400 1 74 1.74
Based on “Asia Renal Care” HBS Case Study 9-800-243
Bottom up revenue projections Bottom‐up revenue projections
Bottom up revenue projections Bottom‐up revenue projections • Basic idea – Define basic unit of product / service Define basic unit of product / service – Estimate customers purchasing units – Multiply by average price – Estimate customer growth over time Estimate customer growth over time
• Approach focuses on ability to deliver!
Example: Fast Ceviche Example: Fast Ceviche • Revenues from typical customer – Ceviche + side dish + drinks = £10
• Number of customers and hours of operations – Lunch: 50 customers L h 50 t – Afternoon: 20 customers – Evening: 50 customers Evening: 50 customers
• Number of days in operation – 5 days a week; 48 weeks y
• Total annual revenues – £10 * 120 = £1,200 daily revenues – £1,200 * 5 = £6,000 weekly revenues – $6000 * 48 = £288,000 yearly revenues
• Ramp‐up to total revenues?
Combining Top Down and Bottom Up Combining Top‐Down and Bottom Up • Construct Market Share: MS = BU / TD Construct Market Share: MS = BU / TD – BU = Bottom up counting – TD = Top down market size p
• Case 1: MS < 10% – Small market share – Market segment defined too broadly – Bottom‐up strategy too conservative
• Case 2: 10% < MS < 100% – Is market share realistic? – For MS > 50%: why can you dominate the market F MS > 50% h d i t th k t
• Case 3: MS > 100% – Stop dreaming: market doesn Stop dreaming: market doesn’tt support growth strategy support growth strategy
Copy Cats and More of the same Copy‐Cats and More‐of‐the‐same
Copy Cats and More of the same Copy‐Cats and More‐of‐the‐same • Industry comparables • Competitor comparables • For established businesses: use own recent growth rates • Past performance is not a reliable indicator of future performance • Works best at top of S‐curve
The S curve The S curve Revenues Over-estimate rapid growth Reasonable R bl estimates ti t off stable growth
Under-estimate Under estimate early growth
Time
COST PROJECTIONS
27
Cost of goods sold (COGS) Cost of goods sold (COGS) • Estimate cost of sourcing physical inputs Estimate cost of sourcing physical inputs • Express as % of sales, but... • With “increasing returns to scale” COGS decrease with volume, due to input fixed costs, volume with volume, due to input fixed costs, volume discounts, etc… • With With “decreasing decreasing returns to scale returns to scale” COGS increase COGS increase with volume, due to capacity constraints
• Estimation methods E ti ti th d • Direct cost estimates from suppliers and experts • Inferred from competitor cost ratios
Example Coffee Costalot: C ff C t l t Market leader Price of standard cup: £4 Cost of good sold: £2 f COGS / Revenues = 50% Gross margin of 100% Profit of £2 per cup Profit of £2 per cup
Coffee Cheapo: Coffee Cheapo: Start‐up challenger Cheaper price: £3 Use Costalot ratio: 50% Cost of goods sold: £1.5 Gross margin of 100% Profit of £1 5 per cup Profit of £1.5 per cup
Example Coffee Costalot: C ff C t l t Market leader Price of standard cup: £4 C Cost of good sold: £2 f d ld £2 COGS / Revenues = 50% Gross margin of 100% Profit of £2 per cup Profit of £2 per cup
Coffee Cheapo: Coffee Cheapo: Start‐up challenger Cheaper price: £3 Use Costalot ratio: 50% Cost of goods sold: £1.5 Gross margin of 100% Profit of £1 5 per cup Profit of £1.5 per cup
Example Coffee Costalot: C ff C t l t Market leader Price of standard cup: £4 Cost of good sold: £2 f COGS / Revenues = 50% Gross margin of 100% Profit of £2 per cup Profit of £2 per cup
Coffee Cheapo: Coffee Cheapo: Start‐up challenger Cheaper price: £3 Realistic COGS: £2.40 COGS / Revenues = 80% Gross margin of 25% Profit of £0 5 per cup Profit of £0.5 per cup
Expenses • Cost of facilities and equipment q p – Rent/lease: recurring expense – Own: one‐time capital expenditure
• Labour expenses – Salary, Benefits, Training costs, Bonuses – Stock options? S k i ? – Founder salaries?
• Other expenses Other expenses – – – –
Marketing and Sales Legal g Admin Overhead Etc…
Budget for founder salaries? 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! a o ea so e g be e a a e soup – Write employment agreement – Define founder salary Define founder salary – Take reduced salary for initial years
Development cost projections Development cost projections • “Mundane” set‐up costs – Legal, Licenses, Office space, Basics
• Pre‐revenue development plan – Short for restaurants Sh f – Long for biotechs
• Main development costs Main development costs – Employees (see expenses) – Capital expenditures (e.g. equipment) p p ( g q p ) – Cost of licensing‐in technology, protecting IP
• Define milestones and timing – Define demonstrable progress markers • Prototype, Beta customers, etc…
– Difficulty of predicting ‘pivots’ Diffi lt f di ti ‘ i t ’
Taxes etc Taxes etc… • Taxes to be paid – VAT – Corporate taxes – Industry specific levies Industry specific levies
• Tax credits – Differ by country, industry, over time, etc…
• Other – Interest payments
Example of “operating Example of operating stacks stacks”
100% 90%
15% 10% Net earnings
80% 70%
Overhead 40%
M&S
60%
R&D
50%
COGS
40%
15%
30% 20%
20%
10% 0% % of revenues
INTEGRATED INTEGRATED PROJECTIONS
Some useful links Some 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)
• Hellmann Model http://strategy.sauder.ubc.ca/hellmann/ – Goldilocks says: (Just right)
• WWW – Lots of models freely available
Fundamentals versus Pro Formas • Fundamental projections: – Bring together all revenues and costs – Pay attention to timing of cash flows
• 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 B l h t • Estimate “book value” • Resilience Resilience
How long, how often, how detailed? How long, how often, how detailed? • Length – Minimum 1‐2 years; typical 3‐5 years; maximum ??? 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 Frequency – Monthly: “only the paranoid survive” – Quarterly: Quarterly: “balanced balanced approach approach”;; still captures seasonality still captures seasonality – Yearly: “big picture”
• Detail – In a presentation only shows highlights – Be ready for justifying each number!
Cash Flow Forecastingg Monthly Cash Balances
Quarterly Cash Balances 45000
45000
40000
40000
35000
35000
30000
30000
25000
25000
20000
20000
15000
15000
10000 10000 5000 5000 0 0 Q1
Q2
Q3
Q4
Q5
‐5000
CASH FLOW CASH FLOW MANAGEMENT
Working capital Working capital • Working Capital = Current assets – Current liabilities • If working capital positive: cash burn! g p p – Need cash to run the business
• If working capital negative: cash machine! – Get paid before delivering services p g
• In growing business, positive working capital means cash burn increasing over time Beware of the fume date!!! • Beware of the fume date!!!
Hellmann’ss Haiku Hellmann Haiku
TAMO = Then A Miracle Occurs TAMO = Then A Miracle Occurs
Trade credit • Prerequisites – Repeat purchasing R h i – Good customer standing
• Standardized terms (industry specific) – Pay in less than x days to get discount (1‐d) Pay in less than x days to get discount (1 d)*p p – Pay in less than y days and pay in full (p) – Pay in more than y days and pay incur penalty
• Trade credit looks attractive to cash‐ constrained entrepreneurs • Trade credit can be surprisingly expensive T d dit b ii l i – Do the math!!!
Implied capital cost of trade credit Implied capital cost of trade credit Discount
Extra Days
1%
2%
3%
5%
10%
15
27.28%
62.40%
107.72%
242.48%
1153.66%
30
12.82%
27.43%
44.12%
85.06%
254.07%
45
8.37%
17.54%
27.59%
50.73%
132.31%
60
6.22%
12.89%
20.05%
36.04%
88.17%
90
4.10%
8.42%
12.96%
22.77%
52.42%
120
3.06%
6.25%
9.57%
16.64%
37.17%
CLASSIC CLASSIC MISTAKES
Classic mistakes (I) • Revenues – Overestimate speed of revenues Overestimate speed of revenues – Unjustifiable revenue spurts – Missing costs of generating sales – Distinguish listed and actual average price g g p • Cost – Forget costs of running business Forget costs of running business – Plan for underutilized assets – Full labor costs • including benefits, training, bonuses, etc…
Classic mistakes (II) • Cash flows – Late payments and collection costs – Underestimate true cost of trade credit – Underestimate delays in raising funding • Overall – Ignore industry norms – False precision – Too much detail – Mismatch between financials and business plan
Final words of wisdom Final words of wisdom Cash flows C h fl are more important p than your mommy!
Thank You! Thank You! • • • • • •
Thomas Hellmann Professor of Entrepreneurship and Innovation Saïd Business School, University of Oxford Park End Street, Oxford OX1 1HP, UK T: +44 (0)1865 288937
[email protected]
APPENDIX
PRESENTATION PRESENTATION EXAMPLE #1 EXAMPLE #1
Financial Projection $120 $100 $80
$Millionss
$60 $40 $20 $ $0 ‐$20 Total Revenue Gross Margin Total Operating Expenses Income Before Int & Taxes
2012
2013
2014
2015
2016
$8,800 ($18,939)
$132,800 ($175,748)
$864,000 ($48,167)
$21,160,000 $9,971,397
$99,550,000 $48,566,526
$2,642,643 ($2,661,581)
$6,339,171 ($6,514,919)
$12,303,334 ($12,351,500)
$21,733,046 ($11,761,650)
$43,654,877 $4,911,649
Operating Stacks 84%
15%
PRESENTATION PRESENTATION EXAMPLE #2 EXAMPLE #2
Financials: Business Model
Unit economics Unit economics
Annual Recurring Annual Recurring
Sale Price: $3250 $
Premium Package: $500
Unit Cost: $1700
Annual Costs:
‐ Goggles / Sensor $950 gg / $
‐ Extended Warranty Extended Warranty
‐ Gloves $400
‐ Live Tech Support
‐ Accelerometer $350 Accelerometer $350
‐ Training Website Training Website
U it Gross Unit G Margin: M i 40%
Financial Model: Assumptions p Product per Customer per Customer
•1
• 50% Uptake of Premium Package • 2% Target Market Entry Share
Growth Rate Growth Rate
• 2% + 1%n years 2% + 1%
Inventory
• 10% Annual Sales
Salary
• +5% Annual
S ft Software Updates U d t
• Quarterly Q t l
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 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 % 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
N tI Net Income
‐0.8 08
‐0.7 07
0
09 0.9
22 2.2
49 4.9
Revenue and Net Income
P b k Payback X
Break Even Break-Even Point X
S d Round Seed R d1 X
X
Operating p g Stacks
PRESENTATION PRESENTATION EXAMPLE #3 EXAMPLE #3
Millions
R Revenue & Market Penetration &M k P i $160 $160
$152 $152
100% 90%
$140
80%
$116 $116
$ $120
70%
$100
60% $76
$80
50% 40%
$60 $41
$40
30% 30% 23%
20%
15%
$20 $20
10%
8%
$‐
0% 2013
2014
2015
Revenue
2016
2017
Market Penetration
2018
2019
G Go to Market M k 2013 Sales
Alpha p customer
Head Count Cou
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
A Assumptions i 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 Wholesale price of $75 00
Slow Medical Market
• 15% penetration in 5 years • 30% penetration in 7 years
Class I Device
• No FDA approval No FDA approval • 90 day pre‐market notification
Steady Adoption
• Growth rate is linear
Millions
Fi Financial Projections i lP j i $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
O Operating Stacks i S k 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
F di Mil Funding Milestones 2013 Cash R 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 $ MM $5
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
