Projections, Budgeting and Forecasting MBA Mondays is starting a new topic this week. It's a big one and I think we'll end up doing at least four and maybe even five posts on this topic in the coming weeks. I said the following in one of my first MBA Mondays posts: companies are worth the "present value" of "future cash flows" The point being that the past doesn't matter too much when it comes to valuing companies. There is another big reason why projections matter. And finally, projections matter because they tell you what your financing needs are. There are three important kinds of projections. 1) Projections – These are a set of numbers, both financial and operational, that you make about your business for various purposes, including raising capital. 2) Budgets – These are a set of numbers, both financial and operational, that the management team prepares each year, usually in the fall, that outline what the company plans to achieve in the coming year. I've been working with Return Path for ten years now.
On startups burn rates • Board Observers Bill Gurley gave an interview a few weeks ago in the WSJ where he sounded alarm on the very high cash burn rates of big startups these days. It triggered an immense debate as he was immediately echoed by Fred Wilson, this “Winter is coming” post from Techcrunch post along with deeper commentary from Mark Suster or Danielle Morill. The trade-offs between profitability and growth is one of the most fundamental and (generally) misunderstood business topic in the startup ecosystem. Here I’ll explain why there is no “right” amount of burn for a company, and I’ll try to give you some frameworks you can use for thinking about this problem. Frameworks The first item is to remember that you should take all advice as directionally good guidance, but every business is different. What are the frameworks you can use to determine the optimal burn rate for your company? The milestone play The “milestone play” consists in getting your company to a point at which you can raise money at a higher valuation.
Scenarios In last week's MBA Mondays, I introduced the topic that we'll be focused on for the next month or so; projections, budgeting, and forecasting. In that post, I described projecting as a "what if" exercise that is done at a higher level of abstraction than the budgeting and forecasting exercises. I said this about projections: These are a set of numbers, both financial and operational, that you make about your business for various purposes, including raising capital. Since projections are not budgets and are much more "big picture" exercises, it is important to use a scenario driven approach to them. If you build your projections with a detailed set of assumptions and if you can assign probabilities to each assumption, you could easily do a monte carlo simulation in which literally thousands, or tens of thousands, of scenarios are run and the outcomes are charted on a bell curve. A few weeks ago on MBA Mondays we talked about key business metrics. Let's get specific here.
Pricing A Follow-On Venture Investment Today on MBA Mondays, I am going to walk you through some math that our team does when looking at a venture investment in a company that is starting to scale its business. Let's assume we have a portfolio company. I will call it fit.sy. So now the VC firm (us) needs to figure out what is a fair price. - fit.sy is on track to generate $10mm in gross transactions in 2011 - they operate on an all-in "take rate" of 9% so their net revenue in 2011 will be $900k - they will have operating costs in 2011 of $1.5mm and they will lose $600k this year - they plan to triple gross transactions in 2012 to $30mm and grow to $150mm in gross transactions by 2014 - they plan to do this while ramping operating costs to $3mm in 2012 and to $7mm in 2014 We lay all of those number out in a spreadsheet and then look for some multiples to apply to them to get to a sense of value. I've observed these multiples over a long time, going back to eBay and Mercado Libre a decade or more ago.
End of the year startup checklist I call the last working week in December Board Week because it’s packed with board meetings. These board meetings are often the most important of the year. By virtue of their place on the calendar, everyone in the room is thinking more strategically, less tactically. These meetings set the tone and strategy for the company for the upcoming year. I’ve assembled a checklist below of top 5 things I’ve seen founders do in and around the end of the year that position their companies for success in the next year. An annual post-mortem. For startups, founders and VCs, the end of the year is a good time for introspection, evaluation and communication.
Determining Valuation Multiples Last week on MBA Mondays, I talked about valuing an internet marketplace business. In that post, I talked about using 1x gross marketplace transactions and 20x EBITDA as multiples to determine value. In the comments, I was asked about multiples for other sectors. That's a good question so I figured I'd show how to calculate multiples for various sectors. For this exercise we will focus on the software as a services (SAAS) sector. The first thing you need to do is find a universe of publicly traded companies to use for your model. The next thing you do is create a spreadsheet with a bunch of companies on it. Please don't get too caught up in the numbers in the spreadsheet. For each company, I collected revenues and EBITDA for 2011 and 2012 and current values for market cap, cash and debt. I then put all the numbers down and used formulas in the spreadsheet to calculate enterprise value which is market value minus cash plus debt. The results of this exercise are as follows:
Balancing predictability and ambition in startups Last week I wrote about the importance of a financial plan for startups at every stage. It’s a challenge to balance the predictability the board requests and the ambition the company wants. Often, as startups grow, they adopt two plans: a board plan and a company plan. By creating two plans and presenting each to the right audience, founders can communicate and motivate their teams effectively. The board plan is the more conservative of the two. Typically, the founding/management team has a high degree of confidence in the board plan, something like 90% confidence. The company plan is the stretch plan, a 70% confidence plan. In practice, having two plans instead of one or none at all may seem like an additional complication. The alternative, having only one plan that contains the stretch goals for employees and is also presented to the board, is a recipe for stress. Managing expectations only increases in importance as companies become larger.
Always have 18 months of cash in the bank tech I was once told by an experienced entrepreneur (I can’t remember who) to always have at least 18 months of cash in the bank. The logic behind this is: 1) as a rule of thumb it takes 3 months to raise money, 2) building/marketing/selling technology always takes longer than you think. More adventurous entrepreneurs might argue 18 months is too conservative. The question of when to raise money is one of the few times that entrepreneurs and early-stage investors have somewhat divergent economic interests.
Financial planning for startups Over lunch last week, I asked a Redpoint entrepreneur, who had recently sold his company, how his board could have been more helpful to him. His answer surprised me. He wished the company had built a financial/operational plan sooner. Building an financial plan is challenging and it is often perceived as a waste of time because the plan can be so inaccurate. But, in the words of this entrepreneur, financial planning helped him sleep better at night - even if the plan was a guess. Reverse engineer the next round - For most of the life of a startup, the company is targeting a subsequent round of financing and working towards a milestone to underpin the financing. The financial plan may never be accurate.