Category Archives: About Offtoa

Team of skilled designers and business people working together on a project

Want to Help Aspiring Entrepreneurs?

Offtoa has released a crowdfunding project on Fundable, https://www.fundable.com/offtoa-inc, aimed at raising capital and ultimately providing new features that our customers are requesting.

150 entrepreneurs have used Offtoa during the past two years to help them launch their businesses by automatically generating financial statements from just their business assumptions.

Most entrepreneurs have to iterate their assumptions several times to determine if their business ideas are feasible, and if so, how much cash they would need. Once they have credible financial statements, they can

  • demonstrate to lenders and investors that they understand their product, market, and team, and
  • hone their business strategies to optimize financial results.

Now it is time for Offtoa to raise some cash so we can help many more aspiring entrepreneurs and give them additional features. We’ve set a goal of raising $15,000 in 60 days. If we don’t raise at least that much in that time frame, then we won’t get anything at all, and we won’t be able to help the next generation of entrepreneurs.

We really need your help. We created some terrific rewards in exchange for your pledges. They include access to Offtoa itself, cool Offtoa hats, copies of my latest book, and personal startup consulting time from me. If you just want to contribute to our success, and the success of others, you can pledge any amount using Tier A.

Select this link now https://www.fundable.com/offtoa-inc to get all the details along with information about Offtoa, our product, and our vision.   You can also check us out here:  www.offtoa.com.

Startup Financial Statements: Why Not Excel®?

No Excel
When you are considering launching a new company, you need to create pro forma financial statements. There are three reasons:

  1. You want to make sure that the business path you are on could result in satisfactory financial results,
  2. Potential investors are going to want to see them, and
  3. The earlier you create them, the earlier you’ll know what underlying business assumptions you need to achieve.

The transformation of all your business assumptions (like product price, rate of sales growth, customer acquisition cost, and so on) into financial statements is “just” a massive combination of mathematical formulas, so why not “just” use Microsoft Excel®?

Well, the transformation of all your income and deductions into your annual federal income tax returns is also “just” a massive combination of mathematical formulas, so why don’t you “just” use Microsoft Excel for your taxes?

The answer is the same for both cases! The transformations are non-trivial, error-prone, and extremely time-consuming.

I admit it. For 20+ years, I did use Excel to build customized spreadsheets to create pro forma financial statements for 40+ startup companies. Each took me a few hundred hours to create. Let me say that again:  each one took a few hundred hours!

Much of that time was spent debugging all the formulas, especially the ones relating to depreciation of fixed assets, interest on loans, cash flows for accounts receivable and accounts payable, and option packages for employees.

For those of you who have done this a few times, you know that the problems usually manifest themselves as the cash balance on the cash flow statement doesn’t equal the cash at the top of the balance sheet :).

I’m a lot smarter now.

Why Use TurboTax® (or an Equivalent) for Income Taxes?

The reasons are:

  1. Your goal is to do your taxes, not to program or debug formulas.
  2. You want to spend your time earning income, not filing taxes.
  3. You don’t want to make mistakes.
  4.  TurboTax will walk you step-by-step through all your income and deductions, or if you insist, you can use its checklist and do them in any order you like.
  5. TurboTax will warn you of missing items.
  6. TurboTax will let you know of problems with your return that the IRS will not like.
  7. TurboTax will provide advice on how to fix any problems.
  8. TurboTax makes sure you have a complete set of all forms and schedules necessary for your Federal and State returns. For example, if you have capital gains, TurboTax adds Schedule D; if you have none, it excludes Schedule D.
  9. You get tips on how to reduce taxes or how to maximize itemized deductions.

Why Use Offtoa™ (or an Equivalent) for Financial Statements?

The reasons are:

  1. Your goal is to create your pro forma financial statements, not to program or debug formulas.
  2. You want to spend your time running your startup, not creating financial statements.
  3. You don’t want to make mistakes.
  4. Offtoa will walk you step-by-step through all your assumed sources of revenue and expenses, or if you insist, you can use its checklist and do them in any order you like.
  5. Offtoa will warn you of missing items.
  6. Offtoa will let you know of problems with your financial statements that your potential investors will not like.
  7. Offtoa will provide advice on how to fix any problems.
  8. Offtoa makes sure you have a complete set of financial reports (income statement, balance sheet, cash flow statement) for five years (monthly, quarterly, and annually), plus extensive graphs. If you expect to have investments, Offtoa includes capitalization tables and estimated internal rates of return (IRR) for your investors based on industry average valuations.
  9. You get tips on how much cash you’ll need, or when you’ll become profitable.

Summary

If you have unlimited time, yes, you should do your income taxes using Excel and you should create your startup’s financial statements using Excel.

But if you are a busy entrepreneur and want to spend your time running your company, use a tool to transform your business assumptions into pro formafinancial statements.

About the Author

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He was a founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003. He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting and optimizing their business strategies. Click on the following to see a short video on Offtoa:

Microsoft, Excel, and the Excel logo are registered trademarks of Microsoft Corporation. Intuit and TurboTax are registered trademarks of Intuit, Inc. Offtoa is a trademark of Offtoa, Inc.

4 Things You Must Do When Starting a Company

BXP135658The lean startup movement (of which I am a big proponent) has thankfully eliminated the “build it and they will come” attitude among aspiring entrepreneurs.

In its place, most new entrepreneurs build minimally viable products (MVP), test them with real customers, receive feedback, adapt and refine, and continually repeat until they find a product that customers like (at a minimum) or ideally, crave.

This new process reduces risk, minimizes cash burn, allows companies to fail early, and allows investors to put their larger investments into only those companies that look like potentially big winners.

However, it also puts a very heavy emphasis on the product – an emphasis that can result in distracting startups away from other essential activities that when initiated at the start of a business can help to identify and reduce other risks just as enormous.

The Biggest Risks

Those risks will vary from company to company and industry to industry, but some risks are common to all startups:

  1. Will customers crave your product?
  2. What will customers pay for your product?
  3. Are their sufficient numbers of customers?
  4. How will you make customers aware of your product?
  5. What will it cost to produce your product?
  6. What will it cost to run your company?
  7. How much cash do you need?

So how does a startup manage these risks from their inception and consistently?

Reducing Those Risks

The popular iterative process described in the second paragraph of this article addresses risk #1 very well. If pricing experiments are included, it can also address risk #2.

Addressing risk #3 requires some level of market and industry research. I’m not suggesting a major effort here, but I am suggesting that you spend at least some time understanding market segmentation, the competition and which segments each competitor aims for. Make sure you include substitute (indirect) competitors.

Failure to address risk #4 early is perhaps the most common mistake of newbie tech entrepreneurs. Often, they’ll think “once we figure out what the product is, then we’ll figure out how to sell it.” This is just a few steps away from “make it and they will come.”

Another common attitude among newbie tech entrepreneurs is “oh, the internet will take care of sales.” The fact is making sales takes work for 99% of companies. Internet sales are not easy! And margins when selling through Amazon are close to nil.

Iterate on your sales model just like you iterate on product features. Start with an initial proposal (based on serious thought!). Then iterate as you learn more. Some of your basic options include inside sales force, outside direct sales force, sales channels/distributors (e.g., Amazon), and internet sales from your own website along with a major SEO effort. Each choice has major impact on your costs and thus your viability as a company.

The easiest way to address risks #5-#7 is to create a quick financial model.

  1. First, make a list of all your business assumptions; this is a good idea to keep you organized in your experiments anyway; after all, it is these very assumptions that serve as the hypotheses that you are testing in your lean startup experiments.
  2. Use a tool to automatically transform the assumptions into pro forma financial statements. These financial statements will then tell you (a) when you will be profitable, (b) when you will break even, (c) how much cash you will need, and (d) what your company’s valuation will be based on industry averages, and (e) what kind of return your investors are likely to receive.

The actual process of entering data for business assumptions should take you no more than 30 minutes. But the real value of using a tool that requires you to write down your business assumptions is the thinking that it inspires you to do. For example, for manufactured products, it asks you questions about what you assume the cost of raw materials will be; for software products, it asks you questions about how many customer support people you plan to hire, and so on.

Remember, these are just assumptions, so you can launch your company with your eyes wide open. You don’t want to start a company that you know will be unprofitable from the start.

I am not advocating for a full business plan. On the other hand, I do not believe that just having the right product is a sufficient first step. Instead you need (from the start!) to be engaged in at least four simultaneous risk-reduction activities:

  1. Building an MVP and then iterating it until customers crave it
  2. Studying the market, segmentation, and competition
  3. Assuming a sales model and iterating as more is learned
  4. Building a financial model based on assumptions and iterating as more is learned

Here are some examples of why just getting the right product is not good enough:

Why the “Right Product” is Not Sufficient: Example 1

Let’s start with a hypothetical case. You have created a product that provides a special nutritional source for pregnant women in Niger, to help reduce the country’s 14% rate of maternal death during childbirth.

You can run a series of experiments to determine if the product is palatable and refine it if necessary. You can also run a series of experiments to determine its efficacy on reducing deaths.

However, the biggest hurdles are not the product’s features. The biggest hurdles are logistics, costs, prices, and everything else that makes up the business.

Why the “Right Product” is Not Sufficient: Example 2

Turning to a simpler example, suppose you are building an app. You can tweak it based on myriad experiments until you have the product that customers love. But if customers expect to download the app for free, you have no business.

 

Why the “Right Product” is Not Sufficient: Example 3

Let’s look at another example, this time from a real company: This company planned to manufacture industrial lubricants with very unique properties and capture a large percentage of the market by (a) marketing unique differentiators that were the result of unique raw materials that were “green,” and (b) price the products well below competition.

That sounded like a great value proposition for all stakeholders. However, a careful early financial analysis revealed that the green raw materials drove the cost of goods sold up to around 85% of the planned price. This left just a 15% gross margin, far too low to support infrastructure costs. A financial analysis at the beginning revealed that this company was a non-starter.

Why the “Right Product” is Not Sufficient: Example 4

Let’s look at one final example, another real company: Adapta Medical. Founded by Dr. Glen House, and based on his numerous patents, Adapta iterated on and perfected an intermittent urinary catheter that an individual with limited dexterity (e.g., a C6-C7 quadriplegic) could use to self-catheterize.

From the beginning, Dr. House experimented with product designs, customer satisfaction experiments, multiple manufacturing sources, and financial models, simultaneously. The tasks that took the longest time and consumed the most energy were working out the manufacturing and cost models. Fortunately for him, he started on these from the beginning, so after about a year product iteration (to arrive at the first commercially viable product), he only had another two or so years to work out the manufacturing and cost model glitches.

Now that he is in production, he continues to perfect the product, iterate on the financials, hone the costs, and adapt the manufacturing processes. Learn more about Adapta at www.adaptamedical.com.

Summary

These days, everybody thinks they can launch a new company. The popular process of “iterate the product until customers like it” provides necessary but not sufficient assistance to the naïve first-time entrepreneur. At a minimum, an entrepreneur must start with these four activities to mitigate the risks of starting a business:

  1. Building an MVP and then iterating it until customers crave it
  2. Studying the market, segmentation, and competition
  3. Assuming a sales model and iterating as more is learned
  4. Building a financial model based on assumptions and iterating as more is learned

Start doing all of them at the beginning; don’t do them sequentially.

About the Author

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books. He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like a tool that transforms business assumptions directly into pro forma financial statements, check out www.offtoa.com.

 

 

Starting Line Photo Credit: “Female Track Athletes at Starting Line” by Tableatny (Creative Commons)

Risk Photo Credit: “Los Angeles Graffiti Art” by A Syn (Creative Commons)

Niger Flag Photo Credit: “Niger Flag” by Philippe Verdy (Wikimedia Commons)

Not for Sale Photo Credit: “Onis Not for Sale Sign” by Noblestrawberry (Creative Commons)

Startups: When Will You Be Profitable?

When Profitable PhotoAs the founder of a startup company, you should be able to determine when you will be profitable. But how can you do that before you even start?

The answer is you need to make some assumptions. In fact, you need to make many assumptions. It is very important to record all these assumptions because during the first few months of your company, you will have to create experiments that validate whether or not these assumptions are true.

So the first step in determining when you will be profitable is recording all your assumptions. See my earlier blog, What Assumptions Does an Entrepreneur Make, for a sample list of such assumptions.

The second step is to create a pro forma income statement based on those assumptions. If you are not familiar with what an income statement is, see my earlier blog, Seven Things an Income Statement Tells You.

The third and last step is to examine the row of the income statement labeled EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization) from left to right looking for the first entry that is positive. If that entry is in the second column, then the answer is you will be profitable in the second year of your business. If it is in the third column, then the third year, and so on.

Most startups are not profitable in their first year. This is because of high starting expenses, as well as the inevitable high cost of goods sold associated with low volume sales. So, if your assumptions show you as profitable in year #1, you may want to rethink your assumptions. And if you are seeking investment capital, I can assure you that investors will look more favorably upon your enterprise if you show realistic numbers, not overly optimistic ones.

 

ABOUT THE AUTHOR:

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
Photograph of CoverIf you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense (and also as a tool to transform your assumptions into financial statements), sign up for www.offtoa.com.

Mine

Five Fatal Flaws in Financials

One of the first and most important steps to take before you launch your startup company is to create pro forma financial statements to verify that your company makes financial sense if all the assumptions that you are making end up becoming true.

The three pro forma financial statements we will be referring to are the income statement, cash flow statement, and the balance sheet.

Three types of “financial sense” can be derived from the above financial statements:

  • Fatal flaws: These are conditions in your financial statements that indicate that the company cannot survive. These are the subjects of this blog.
  • Universal non-investible flaws: These are conditions in your financial statements that make it highly unlikely that any right-minded investor would consider investing in your endeavor. The presence of universal non-investible flaws implies that the company could survive but will not produce extremely good financial returns.
  • Situation-specific flaws: These are conditions in your financial statements that may or may not preclude good financial returns, depending on the specific industry or unique situation.

Fatal Flaw 1. Negative Cash

The bottom line of every column of the monthly cash flow statement is always labeled “Cash at End of Period.” It tells you (based on all the assumptions you have made about your company) how much cash you will have in your company’s bank account at the end of every month.

No entry in this row can be negative.

If some column has a negative value in this row, you must do something to your assumptions prior to this month, for example (these are just four of dozens of possibilities),

  • Get a loan
  • Raise money in an investment round
  • Sell more product
  • Spend less money (on expenses)

What you cannot do is just launch the company and hope that things will work out. Hope is not a strategy. The fact is many things will change once you launch, but you have to at least start with a plan that has a fighting chance of working.

Fatal Flaw 2: Negative Gross Profit

Near the top of every column of the annual income statement will be lines for

Revenues
– Cost of goods sold      
Gross profit

Gross margins indicate how efficient the company is at acquiring and using raw mate­rials for its products. Different industries tend to experience radically different gross margins based on (a) inherent cost of goods sold within those industries, and (b) level of price competition.

Your company can tolerate a negative gross profit in its first year while you figure out pricing, find best suppliers, and hone manufacturing and internal processes. However, by year 2, you had better have a positive gross profit.

New companies rarely emerge in industries where gross margins are low. Reasons should be obvious: investors will likely not see a return on their investment based on an ROE calculation.

Here are some ideas on how to increase gross margins:

  • Decrease cost of raw materials. This is the most straightforward method to reduce cost of goods sold, and yet it is the most dangerous because of potential to adversely affect product quality.Some ways are: (a) find alternative suppliers, (b) replace expensive components with less costly substitute components, especially when customers are unlikely to perceive the difference, (c) use less of a raw material in your product, and (d) purchase in larger volumes
  • Outsource, insource, offshore, or onshore. Find the lowest cost source of doing tasks while still maintaining acceptable levels of quality.
  • Increase prices.
  • Change the product. If your product cannot be sold profitably, consider selling a simpler product that solves fewer customer problems and price it lower. Or consider selling a larger product that addresses more customer pains and price it higher. Or maybe you should rent or lease the product instead of selling it?

Fatal Flaw 3: Insufficient Cash from Operations

The top third of the annual cash flow statement captures cash flows in or out of the company that result from the core business of the company. The bottom line of every column of this top third is always labeled “Net Cash Provided (Used) by Operating Activities.” It tells you (based on all the assumptions you have made about your company) how much cash the company’s business is generating without the contributions of loans, investments, or sales of property.

Almost all startups experience negative cash from operations for the first few years. During this time, they rely on infusions of cash from external sources such as investments or loans.

However, a successful company must at some point be self-sufficient; it must be able to sustain itself with being on life support.

It is possible that a high-growth company with a huge market could plan to stay on a high-growth trajectory for many years and continue to need capital infusions to fund its growth. So, I guess the best way to describe this fatal flaw is to ask if the cash from operations would be positive if the cash from financing were set to zero.

Fatal Flaw 4: Current Ratio Less than One

On the annual balance sheet, divide current assets by current liabilities for each year. This current ratio gives you a pretty good indication of whether your company will be in a condition to pay off debt when it becomes due.

A value less than 1.0 indicates that the company is going to have problems, although there could be short-term fixes for short-term problems. As your company evolves, your current ratio should become (and remain) above 1.2.

If your current ratio is less than zero, it means your current assets are negative (current liabilities can never be negative), so this is equivalent to fatal flaw 1.

Fatal Flaw 5: No Profit

Near the bottom of every column of the annual income statement is a row labeled “EBITDA,” short for earnings before interest, taxes, depreciation, and amortization. You can think of it as the company’s profit (without some of the “noise”).

Most startups experience negative EBITDA for the first one or two years, and that is okay. In fact, it is highly unlikely to have positive EBITDA during those first few years.

However, by year three or so, EBITDA should be positive, and stay positive for the remaining years.

Summary

Although many dozens of potential problems can be detected in advance by examining the pro forma financial statements, the above five conditions are easy to detect and are almost always fatal for your company if not fixed. If you find them to be present in your company’s financial statements before you launch, don’t launch! Instead, fix your plan.

After you fix the plan, and know that it is possible to succeed, then launch the company. It is always good to start knowing that failure is not guaranteed.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

Mouse Trap

Eight Things You Never Say to Investors

When you approach potential investors about investing in your new company, you should avoid certain expressions. They are traps that you either make you look weak, or from which you will have a difficult time extricating yourself. Here are some examples.

1. “I have no competitors”

Everybody has competition, even if they offer a substitute product. A sophisticated investor will be turned off immediately if you imply you have no competition.

Every startup launches because its founder has thought of something new. It is either

  • a new product or service, or
  • a new market for an existing product or service, or
  • a new way to deliver an existing product or service.

But just because you have thought of something new doesn’t mean you have no competition. You provide products and services as solutions to customers’ problems/needs/pains. Ask yourself, “How do people satisfy their problems/needs/pains currently?” Even if the answer is “They don’t,” then the status quo is competition!

Let’s look at some examples:

  • A new 3rd generation canine cancer-fighting drug. The competition includes: (a) less effective 2nd generation cancer-fighting drug, (b) not treating the dog (could be cost effective), or (c) pain killers for the dog to enhance quality of life.
  • The first online gourmet recipe ingredient store. The competition includes: (a) general on-line merchandisers like Amazon, and (b) storefront sellers of gourmet food.
  • The first allergy clinic franchise embedded inside of physician offices. The competition includes: (a) standalone allergy clinics, (b) allergists, and (c) physician assistants and nurse practitioners specializing in allergies.
  • The first online bookstore (i.e., Amazon). The competition includes all the brick and mortar bookstores.

Bottom line: just because you are the “first” does not mean you have no competition.

2. “All I need is your money; not your opinions”

Investors, whether angels or venture capitalists, usually consider their business acumen to be of considerable value to their portfolio companies. When you make a statement like this (or imply it through your actions) you will likely alienate the investors sufficiently so they will not invest.

3. “My time is worth as much as your money”

During an investor pitch, investors will often ask “how much money have you raised to date?” They want to know how much cash has been invested in the company so far. All founders devote enormous hours in birthing their companies, but labor hours just don’t count.

Yes, you can and should offer to work for no cash compensation (this could be a factor in encouraging investors to invest), and yes, you can suggest that you will accept options in lieu of such compensation. This is all good.

But don’t go into a monologue explaining how your time is worth $100,000/year, so you have thus far invested $100,000 into the company by working for a year without salary.

4. “I will guarantee you an X% return on your investment”

“Danger! Will Robinson. Danger!” You cannot guarantee anything to your investors. You are selling them securities in return for their payment and the terms of this transaction are spelled out in a written subscription agreement.

When you state that you “guarantee” such a return, you are inviting a class action law suit from investors if such a return is not delivered. Do not do this! And the limited liability of the corporation will likely not protect you as an individual (or your personal assets) from claims by the investors.

5. “This is a risk free investment”

By their very nature, startups are risky. The graph to the left shows the survival rates for startup companies, and emphasizes that the rates have been the same regardless of the year they were started. Notice that only 50% of companies survive for 5 years or more.

But even ignoring the data, making such a statement is foolhardy. You have an obligation (legally and ethically) to potential investors to understand and spell out all the risks involved in investing in your startup.

And your attorneys, when they draft your subscription agreements, will insist on including a clause that spells out the likelihood of total loss of the investment.

6. “All I have to do is build my product and the customers will come”

This is a classic statement made by engineers without any marketing savvy. By saying it, investors will know you are a geek. Only three ways exist to create revenue:

  • You can “buy” a customer. That is, you can spend resources (usually money) to raise awareness of your product, you can pull or push leads to you, and you can spend more resources to convert those leads into customers.
  • You can convince existing customers to buy more, or buy more often, or not stop being your customer.
  • You can encourage existing customers to convert non-customers to become customers.

That’s it! Nowhere in this list is “Build my product and  customers will come.” Creating and growing revenue takes work. Plain and simple. Investors know that. If you don’t know that, you will be seen as naïve, not street smart.

7. “We’re almost out of cash”

The timing of raising capital is always a challenge. If you wait too long (e.g., you get close to running out of cash), less respectable investors could take advantage of your situation by delaying their decision to invest until you are desperate and you may end up being forced to accept less-then-ideal terms.

On the other hand, if you solicit investments too early, company valuations might be lower than you would like, and you may end up having to sell a larger percentage of the company to raise necessary cash. No perfect answer exists, but unless you are about to hit a major valuation-changing milestone, I would err on the side of too-early rather than too-late.

Whatever you do, don’t ever suggest to the investor that you are desperate for cash; that will invite even scrupulous investors to make lower offers. The best advice is manage your company so you are never desperate for cash.

8. “The market is so huge; all we need to do is capture 1/10 of 1% of it.”

This might sound impressive to you, but it doesn’t to the seasoned investor. Investors want to invest in market leaders; they want you to have a large percent of some market. Market leaders lead. Market laggards lag.

Successful startups first focus on penetration of relatively narrow vertical markets; it is called the “rifle shot.” Such an approach enables you to target your desired audience with a marketing campaign designed specifically to their particular pains.

Bragging about a “huge market” and the sufficiency of a tiny capture to “make millions” demonstrates that you don’t understand the dynamics of focusing. It sounds like you are going to take the “shot gun” approach, one that usually results in failure because of overly broad messaging.

In summary

Investors are much better at negotiations than you are; after all, they do it over and over again, and you do it rarely. They have heard all the “lines” before and they can see through BS immediately. They also know how to take advantage of your vulnerabilities if they desire to.

I have a few other cautionary bits of advice. They don’t fit into the category of “never say these,” but they are close:

  • “It will be easy to steal customers from competitors because they provide such terrible customer service.” Competitors may in fact be providing terrible customer service, but never underestimate the power of inertia. Many customers would rather stick with a known, but poor, service provider than venture into the unknown.
  • “Our key differentiator is a great user interface.” Sorry, but every new startup claims that it will provide the greatest user experience. You might actually plan on doing so, and you might even be able to do so, but because you sound like every other entrepreneur, your claim will be summarily dismissed.

 

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

“Clippesby drainage pump – overgrown door” © Copyright Evelyn Simak and licensed for reuse under Creative Commons License. Original photo from Geograph Project.

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What Financial Statements Investors Expect? Why?

You want to start a company and you want to fund the company by raising money from investors. What financial statements will potential investors expect to see?

Let’s talk about what they expect to get from two key phases in securing investment. The first is known as an “investor pitch”. This is a short presentation you deliver to investors about your great business idea.

The second is known as “due diligence”. This is the process investors use to convince themselves that investing in your idea is a sound undertaking . . . or not.

1. Financial Statements During Investor Pitch

If you are interested in attracting investment money from traditional sources such as angel investors or venture capitalists, they will expect you to make a short presentation to them, usually somewhere between 10 and 20 minutes.

Much of that time will be devoted to conveying the problem or pain you are addressing and your unique approach to solving it, but toward the end of the presentation, an entrepreneur usually includes three slides on financials:

  • Key Assumptions
  • Key Financials
  • Cap Table

Key Assumptions.

This slide lists the primary assumptions that you have made that drive the financial results to be shown on the following slide. Include only the most important assumptions.

This is an opportunity for you to demonstrate to investors that you understand what factors are the most critical to your business achieving its financial goals.

Here are some examples, but don’t use these; use the ones most important for your business:

  • Customer acquisition cost < $100
  • Average order size > $350
  • Annual increase in our cost of goods sold < 7%
  • By year 2, we will be able to negotiate ‘net 60’ terms with suppliers
  • Annual customer attrition rate < 20% (i.e., retention rate >= 80%)
  • We will be able to attract an effective VP of marketing for $75,000 plus a 10% equity stake

Key Financials.

This slide captures the most important data from your financial statements on one slide, without requiring a microscope.

Once again, this is an opportunity to demonstrate that you understand what is important. [Here’s one hint: omit cents!] Although the exact selection of data will vary based on the type of business, a good start is 5 columns (for 5 years) and 8 rows showing:

  • Number of units sold (or perhaps number of customers)
  • Annual revenues
  • Cost of goods sold
  • Gross profit
  • Expenses
  • EBITDA
  • Net cash from financing activities
  • Cash balance at end of year

If cost of goods sold is not important to your business, omit it and gross profit. Include a metric or two if you want to demonstrate something critical to your success, e.g., revenue/customer. Many entrepreneurs replace parts of this table with a graph. Here are two examples:

Example I shows key data from the income statement; none from the cash flow statement.

Example II shows key data from income statement graphically; with investment rounds highlighted in text boxes.

Capitalization Table

This slide shows the investors exactly what you are offering them. It shows how equity is distributed among shareholders currently, and how equity will be distributed among shareholders after the current stock offering. You can read more about how to create and interpret a cap table in How to Read a Cap Table: Advice for Entrepreneurs.

2. Financial Statements During Due Diligence

The investor pitch is designed to whet the appetite of the potential investors. If it succeeds, the investors will engage in an extensive process of discovery called due diligence. Its goal is to uncover all material facts.

They will ask questions, do research, and examine documents to determine the true state of the products, technology, competition, market, industry, personnel, financials, sales process, contracts, and relations with suppliers, partners, and customers.

Part of that due diligence process will include careful analysis of past performance (if any) and pro forma financial statements. This will include:

  • Income Statement
  • Cash Flow Statement
  • Balance Sheet

Income Statement.

Monthly for the next two years, and annually for at least the next 5 years.

This enables investors to determine:

  • Revenues and profit at the time of an expected liquidity event, so they can calculate a likely return on their investment
  • Revenue growth rates to determine if they are reasonable
  • Gross and net profit margins to determine if they are similar to other companies in your industry
  • Percentages of revenues being spent on R&D, marketing, and so on, to determine if they are similar to other companies in your industry.

Whenever anything seems unreasonable, investors will ask for clarification and/or explanation. You can read more about the income statement in Seven Things an Income Statement Tells You.

Cash Flow Statement.

Monthly for the next two years, and annually for at least the next 5 years.

This enables investors to:

  • Verify that the company is not going to run out of cash
  • See if you understand the need for sufficient cash cushion to handle unforeseen circumstances
  • Determine how many more investment dollars you will need to raise in the future
  • Learn what loans you will be making
  • Determine what fixed assets you need to purchase in order to conduct the business.

You can read more about the cash flow statement in Four Things a Cash Flow Statement Tells You.

Balance Sheet.

Annually for at least the next 5 years.

This enables investors to:

  • Quickly calculate current ratio and net working capital, to determine if you will be able to stay afloat
  • Compare accounts receivable as a function of revenues to industry averages to determine if you are being realistic with respect to receivables
  • Calculate return on equity.

You can read more about the balance sheet in Four Things a Balance Sheet Tells You.

In summary

Successful entrepreneurs need to be both detail-oriented as well as masters of abstraction. One of the many places where these skills come in handy is in the explanation and interpretation of financial statements.

Before the investor pitch, you should become comfortable with explaining your financials in 1-2 minutes. And yet in response to questions posed during due diligence, you should become comfortable with explaining any aspect of your financials with considerable detail.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

Four Ways to Validate Your Great Startup Idea

You have a great idea for a start-up company.

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Validate your idea by answering four simple questions:

  • Is the market right?
  • Is the industry right?
  • Will it make money?
  • Will it need money?

Let’s explore these one at a time.

1. Is the market right?

Determining if the market is right means demonstrating that enough people exist who will purchase the product or solution you have developed, you can find them, and you can turn them into customers. For this you need to understand the size of your market and the characteristics of the buyers that personify your market.

Size of market

How large is your target market? You want your potential market (called the total available market, or TAM) to be quite large. But you want your initial target vertical market to be relatively small. By being focused, you can align your product features and marketing messaging with the unique pains/needs of this unique market.

And then you can claim you “penetrated 25% of your target market” instead of having to claim that you “penetrated .02% of your target market.” Sure sounds better to future investors!

You can measure the size of both your TAM and your initial target vertical market in terms of:

  • Number of customers
  • Dollars spent on products like yours
  • Units sold

Targeting Customers

NeedleHow easily can you find potential customers? Will they find you? Or will you find them? In either case, how? It is very easy to say “oh, we’ll just use Google AdWords and we’ll get tens of thousands of visitors every day.”

It is much harder to actually attract qualified leads. If you plan on finding the leads, how will you reach them and engage with them until they become customers?

Converting Customers

Catheter Solution 2Converting customers is not only influenced by the severity of pain your product is addressing. It is also influenced by how you position your solution and your messaging. Your target market must be able to identify with what pain your product resolves. The three bullets shown above demonstrate how one company, Adapta Medical, has honed their message to align perfectly with their target markets, C6-C7 quadriplegics and hospitals.

I like to use the words “clear and compelling” to describe the right message, i.e., when a lead hears or reads the message, they can relate immediately to the pain they are feeling and see clearly how your product will alleviate that pain.

2. Is the industry right?

If you want to do a thorough analysis of whether the industry is “right,” check out Porter’s Five Forces. But as a start, make sure you have a thorough understanding of your competitors, your potential partners, and your differentiators.

Competition

Few things turn off investors more than hearing entrepreneurs claim that they have no competitors. Every new company has competitors. If you really are the first to do something, then how are your target customers surviving currently? Here are some examples:

  • You’re “first” to provide on-line retail sales of gourmet food. Your indirect competitors include storefront retailers and catalog retailers of gourmet food. And your future competitors include on-line retailers of non-gourmet food (because they have all the logistics in place to add SKUs for gourmet food and thus become direct competitors).
  • You’re first to provide regular helicopter service from Denver to Colorado’s ski resorts. Your competitors include airlines, van shuttle services, rental car companies, and so on, all of which satisfy your target market with this capability using different means.

The way to determine if a company is a competitor is to imagine being a potential customer. If the customer could make a list of companies (including yours) and evaluate the pros and cons of each alternative (including price, convenience, safety, etc.), then those companies are competitors.

Partners

Look upstream and downstream on your supply chain. Who will you need to work with? Have you established those relationships yet? How easily will it be to establish? Can they control you (e.g., with price changes)? Or can you control them?

Differentiators

Think again about that list of competitors that a potential customer could create. What makes you special? Nobody cares about what you think makes you special! What will a potential customer think make you special when compared with the alternatives?

3. Will it make money?

In his February 20 article, Martin Zwilling explained how critical it is for you to use a financial model to determine if your company will be financially successful given the assumptions you currently believe to be true. I couldn’t agree with him more.

After creating such financial models for many dozens of startups, I would add that it takes many precious hours to create and debug such a model.

I would recommend that you use an online tool that has already considered and built in all the elements you must consider to be successful. Such tools allow you to enter your key assumptions one time, and they create your entire financial model. Then when any of your assumptions change, you just have to change one number, and your new financials are instantly created for you.


 

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Martin provides 5 great examples of such “assumption changes” that are typical:

  • What if customers don’t want to pay the price for your product that you though they would?
  • What if the market size ends up being different than you expected?
  • What if your sales growth is different than expected?
  • What if your investors offer you an investment amount different than your expected?
  • What if your customer acquisition cost changes?

In reality, there are hundreds of such assumptions that could change.

4. Will it need money?

Another benefit of assumptions-based financial modeling is the automatic creation of monthly pro forma cash flow statements. You can easily scan the bottom row of these statements to determine exactly how much investment money you will need and when.

In summary

To prepare yourself for investors, you should thoroughly validate your business before you enter the shark tank. This article summarizes the key elements of such a validation. To summarize, here is the checklist:

☐ Is your total available market large enough?

☐ Is your initial target vertical market focused enough?

☐ Is it easy to find leads?

☐ Is it easy to convert leads into customers?

☐ Do you know your competition?

☐ Have you lined up your business partners (suppliers and distributors)?

☐ Are your differentiators unique and compelling?

☐ Will your startup make money?

☐ When your assumptions change, can you instantly see the financial effects?

☐ How much money do you need?

ABOUT THE AUTHOR:

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

ABOUT OFFTOA

Offtoa is a subscription-based SaaS that leads you, the entrepreneur, through a series of questions and transforms the assumptions you provide into a complete set of pro forma financial statements, including even a capitalization table and expected internal rates of return for the investors. Armed with this intelligence, you and your team are able to demonstrate to investors that you know your finances, understand your market, and have a winning proposition.

If you decide to subscribe to Offtoa because you read this blog, send me an email at adavis@offtoa.com and I’ll email you a coupon good for 50% off your first month’s subscription. This offer good only until May 31, 2015.

Needle in a Haystack photo by James Lumb (Creative Commons).

 

Should you sell investors common or preferred shares?

Photo PreferredPhoto CommonIn most start-ups, founders’ shares are common.  Subsequent investment rounds tend to sell preferred shares to investors, but some start-ups sell common shares to investors.

Why offer preferred shares to investors?

The reason for offering preferred shares to investors is that insiders (like founders and officers) have a huge amount of control over the success or failure of the company whereas outside investors have so little control.

The preferences that come with preferred shares lessen that almost intolerable level of risk.  These preferences reduce risk for their owners, and generally fall into two categories. The categories are downside insurance and upside insurance.

What are “downside insurance” preferences?

Downside insurance preferences provide owners with protections in case the company does not do particularly well. Two examples are liquidation rights and anti-dilution rights.

  1. Liquidation rights give the preferred shareholders a multiple of their initial investment back before a general distribution of the proceeds of a liquidity event. Say the investors purchase their shares for $600,000 and they negotiate 2x liquidation rights.

    A few years later, the company is acquired for $4,000,000.The preferred shareholders would receive 2x their initial investment, i.e., $1,200,000, and then the remaining $2,800,000 would be divided pro rata among all shareholders (including these same preferred shareholders).

  2. Anti-dilution rights give the preferred shareholders a “guaranteed best price” on their share purchase. The preference kicks in only if the company ever sells shares at a future date at a price lower than the current offering.

    Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate anti-dilution rights.

    A year later, the company has run into difficulties and is forced to sell shares at $1 per share in order to attract investors.

    If they succeed in raising this follow-on round, they will have to issue 300,000 additional shares at no cost to the original preferred shareholders (the ones who had the anti-dilution rights); this has the effect of retroactively selling them 600,000 shares at $600,000, so they actually ended up paying the better price of $1 per share.

What are “upside insurance” preferences?

Upside insurance preferences provide owners with some additional benefits in case the company does extremely well. Two examples are registration rights and warrants.

  1. Registration rights allow preferred shareholders to sell their shares at the time of the initial public offering.
  2. Warrants allow preferred shareholders to purchase additional shares at the current price. Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate a warrant to purchase an additional 100,000 shares at $2 per share.

    A year later, the company is doing poorly; the preferred shareholders will not choose to exercise their warrant.

    However, if a year later, the company is doing very well, and the shares are now worth $5, the preferred shareholders may choose to exercise their warrant and purchase the additional shares

In Summary

Some first time entrepreneurs avoid selling preferred shares to investors out of fear that they should not sell something “more valuable” than what they, the founders, own. However, most founders become officers and thus have almost complete control over the company’s success or demise, while outside investors have very little power to influence the success of the company.

Outside investors deserve some ability to reduce their risk and share in the upside. And the only way for them to do that is to negotiate the preferences that go with preferred shares.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will You New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

WYNSUMM CoverIf you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?