Category Archives: About Offtoa

How to Read a Cap Table: Advice for Entrepreneurs

A capitalization table (cap table for short) shows how ownership of the company is distributed among all shareholders. It is the de facto standard entrepreneurs use to show investors what they are buying.

sharks When you are seeking investor money, you are essentially selling something, specifically equity in your company. Providing a cap table when you sell equity in your company is similar to providing a CarFax report to buyers when you sell a used car.

In both cases, you are fully disclosing to the buyers exactly what they are buying. It shows you are honest and reveals (in both cases) material facts that buyers cannot otherwise discern.

Although the cap table is a standard tool among entrepreneurs and investors in private companies, it is not a standard financial statement in a larger corporation.  Learn to read one to be credible to investors.

What Does a Cap Table Show?

A cap table shows in a single table a complete breakdown of the ownership of equity of a company. It displays exactly what classes of stock exist, who owns shares, and how many (and what percentages) of each.

Let’s look at an example where the cap table is being used to show “before” and “after” situations as part of a stock offering. In this case, the stock offering is for 200,000 preferred shares of the company.

Capitalization Table for NewCo, Inc.

 

Before

After

Common

Shares

Undi-luted

Fully Diluted

Shares

Undi-
luted

Fully
Diluted

    George

   250,000

25%

17%

 

   250,000

21%

15%

    Harry

   250,000

25%

17%

 

   250,000

21%

15%

    Sally

   500,000

50%

33%

 

   500,000

42%

29%

Total Common

1,000,000

100%

67%

 

1,000,000

83%

59%

Preferred

 

 

 

 

 

 

 

   Series A Shareholders

        –  

0%

0%

 

   200,000

17%

12%

Total Preferred

        –                               

0%

0%

 

   200,000

17%

12%

Total Common + Preferred

1,000,000

100%

67%

 

1,200,000

100%

71%

Options

 

 

 

 

 

 

 

   Granted

   300,000

 

20%

 

   300,000

 

18%

   Authorized, Not Granted

   200,000

 

13%

 

   200,000

 

12%

Total Options

   500,000

 

33%

 

   500,000

 

29%

Total Fully Diluted Shares

  1,500,000

 

100%

 

 1,700,000

 

100%

Here is a description of the various parts of the cap table shown in the above example:

  • Down the left side, a list of all (classes of) shareholders. In some cases, actual names of shareholders are shown (in the case of the figure, common shareholders’ names are shown). In some cases, they are grouped together as a class (in the case of the figure, preferred shareholders’ names are not shown).
  • Along the top, two groupings of columns are shown; they are labeled Before and After, corresponding to how the company’s ownership looks like before and after the investors make their expected purchase of the 200,000 preferred shares.
  • Along the top, within both Before or After, three columns are displayed:
    • Shares. Number of shares that this shareholder has been issued.
    • Percent undiluted. Percent of total outstanding shares that this shareholder’s shares represent. Thus, if this shareholder owns 250K shares (as is the case of George), and 1M shares are currently outstanding, the percent undiluted is shown as 25% (250,000/1,000,000).
    • Percent (fully) diluted. At this time, a certain number of options have been authorized to be granted to individuals. If all these options were to be granted, and all option holders were to exercise their right to convert those options into shares, additional shares will exist. When we include these shares in the overall count of shares, we call the new count (fully) diluted.

Thus, continuing with the above example, if a pool of 1,000,000 shares have been authorized for options, then George owns 250,000 shares out of a total diluted pool of 1,500,000 shares (i.e., 1,000,000 shares sold plus 500,000 options authorized), then his percent diluted will be 17% (250,000/1,500,000).

Number of Shares

Let’s now compare the Before and After sections. The example above shows the following numbers of shares (see the two columns labeled Shares):

  • The number of founders’ shares is unchanged at 1,000,000. We will almost always see the same number of founders’ shares in every round (unless something unusual happens like a founder sells shares).
  • The number of preferred (Series A) shares increases from zero to 200,000 as we move from before to after. These are the shares that are being sold.
  • The total number of outstanding shares (i.e., total common plus preferred) reflects the same increase, i.e., from 1,000,000 to 1,200,000.
  • The number of options granted and the number of options remaining in the option pool are unchanged at 300,000 and 200,000, respectively.

Undiluted Ownership

It shows the following about undiluted percent ownership (see the two columns labeled Undiluted):

  • Although the number of shares owned by founders (total common) is unchanged, their undiluted percent ownership decreases from 100% to 83% because the total pool of issued shares increased from 1,000,000 to 1,200,000.We will almost always see the percentage ownership of founders decrease with each successive round because the total number of outstanding shares increases. This is because investors generally purchase new shares from the company’s treasury as opposed to purchasing existing shares from current owners.Note that if a founder happens to participate as an investor in a round, those shares are shown on the cap table as owned by the investors in that round, not by the founder.
  • The 200,000 new shares purchased by Series A investors represent 17% of the 1,200,000 total shares.

Fully Diluted Ownership

The cap table shows the following about fully diluted percent ownership (see the two columns labeled Fully Diluted):

  • Once we add 500,000 authorized options to both the before and after totals, the 1,000,000 shares owned by founders represent 67% and 59%, respectively, of the total. Said another way, by selling 200,000 shares to investors, the founders’ ownership stake is diluted by 8%.
  • Once we add 500,000 options to the totals, the 200,000 new shares purchased by Series A represent 12% of the 1,700,000 total fully diluted pool of shares.

A cap table enables investors to understand what they are buying. It enables entrepreneurs to make it clear that they have nothing to hide. In summary, a cap table is an essential tool for communication between entrepreneurs and investors.

Alan DavisThis article is an edited excerpt from the book Will Your New Startup Make Money? by Al Davis. Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.

Why Every Startup Needs a Financial Plan

Assumptions are Important

money-down-the-drainHaving a financial plan for your startup is based on a simple concept. It says “If these assumptions prove true, then these financial results will occur.”

In other words, a financial plan is the place where you determine whether or not your business idea could possibly result in financial success.

To start a business without a financial plan would be like sailing out of port in a sailboat with no navigational tools and no idea where you are going. In the case of the sailboat, your life would be at risk. In the case of a startup company, any money or time you are about to invest is likely to go down the drain.

Notice that I am not saying you need to have all the facts before you launch your company. But you need to at least document the assumptions you are making about the business and verify that if those assumptions end up being valid you have a viable business.

In The Lean Startup, Eric Ries provides us with sound advice for starting a company: State your assumptions and then make many small iterations. For each iteration,

  • Invest as little as possible
  • Build a minimally viable product (MVP), i.e., build something you can show your customers
  • Learn which assumptions are valid
  • Pivot and repeat

Innovation Accounting

As a metric for determining that you are making progress, Ries recommends using innovation accounting (IA). IA is basically checking that assumptions are being verified, the product is progressing toward viability, and the startup is learning – all good things.

Traditional Accounting

I would add just two steps to his advice:

  1. Before you launch, build a financial plan based on your assumptions to verify that financial success is at least possible.
  2. At the end of each iteration, repeat the financial plan to verify that the revised assumptions are still sufficient to support financial success.
 Iteration Ia

A company following the traditional lean startup approach is iterating and “making progress” but it is unclear if it is heading in a financially viable direction.

No Financial Plan;
No Knowledge

 Iteration II

By creating a financial plan, you can learn that the path you are considering cannot result in a great financial result.

Financial Plan Shows Poor Results

 Iteration III

By recreating the financial plan with different assumptions, you can determine that charting an alternative path could result in a far better financial outcome.

Change Path & Financial Plan
Shows Good Results

My advice makes sense only if creating a financial plan is not overly time consuming. The secret is to use a tool that supports automatic generation of financial statements directly from your business assumptions. By doing so, financial planning costs you little but saves you a lot.

???????????????????????????????Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and author of six books.

Why a lean start-up needs a business plan?

Lean Start-ups

First of all, kudos to Paul Jones for a great article on why even a lean start-up needs a business plan: http://technori.com/2013/01/3135-why-almost-every-startup-needs-a-business-plan-lean-startups-too/.

Lean Financials

And to reduce the time it takes to create the financial parts of that business plan, use www.offtoa.com, the first tool that lets you model your start-up using the language of lean start-ups (paid, viral, and sticky growth engines) and automatically generates pro forma financial statements.

 

 

How to read an income statement for a startup

How to read an income statement

When you plan a start-up company, you will need to create pro forma financial statements, including the income statement, cash flow statement and balance sheet. A pro forma income statement (also called a profit and loss statement, or P&L statement) is the tool used by businesspeople to determine if a company is profitable (or not) over a period of time. Specifically, it shows what revenues, cost of goods sold, expenses, and profits of a company would be, based on a set of given assumptions. The figure below shows an example. It is a pro forma income statement for the first 5 years of a start-up. Like every income statement, it is organized into 4 horizontal sections:

Revenues

This section shows all primary revenues sources. Companies categorize revenues in this section in a variety of ways, but two common ways of organizing them are (a) by product (or family of pro­ducts), and (b) by market. This enables readers to understand what the reve­nues sources are. The example shown in the figure has revenues organized by product.

Cost of goods sold (aka COGS)

This section shows costs associated with actually producing products that were responsible for the revenues shown in the previous section. This includes the cost of raw materials, shipping the products to customers, and labor costs associated with manu­facturing and maintaining inventory (and labor costs associated with delivering services to the customer, if that is standard practice within the selected industry). Like revenues, COGS are also often organized by product or by market, or sometimes they appear as just one number. The example shown in the figure has COGS organized by product.

Just below this section, COGS are subtracted from revenues to calculate gross profit. It is used to determine how efficiently your company produces its products. It is most mean­ing­ful when compared to other companies in your industry.

Expenses

This section lists all expenses incurred by the company during the indicated period of time, categorized by corporate division: General and Administration, Manufacturing and Production, Marketing and Sales, and Research and Development.

Summary lines on income statement

At the bottom of the income statement are a series of totals and summaries that help you understand the company. They include:

  • EBITDA. Literally, earnings before interest, (income) tax, depre­ciation, and amortization. Calculated by subtracting expenses from gross profit. This is the value that most investors look at when they are trying to determine how well the company is predicted to do. Also, for most industries, it will be one of the primary determinants for valuing the company in the case of an acquisition or public offering.
  • Depreciation. This is calculated from the depreciation schedules and useful lives of major purchases (i.e., fixed assets) you have made. Specifically, it is the sum of all depreciations applied during the period of this income statement (for major purchases made prior to or during this period).
  • EBIT. Earnings before interest and (income) tax. Calculated by subtracting depreciation from EBITDA.
  • Interest. Any interest earned by the company from its assets, or any interest paid by the company.
  • Provision for income taxes. This is calculated by multiplying your income tax rate by EBIT. However, if you had previous years of accumulated losses, they will be subtracted from the current year’s EBIT first. Notice, for example, in the company shown in the figure, no income tax is shown for fiscal year 3, even though it was profitable; losses from its earlier years were subtracted from its profits of year 3.
  • EAT. Earnings after tax. Calculated by subtracting interest and income tax from EBIT.
  • Cum net. Cumulative net earnings. The sum of all EATs for all periods up to and including the current period.

Pro Forma Income Statement for NewCo, Inc.

Fiscal Year 1

Fiscal Year 2

Fiscal Year 3

Fiscal Year 4

Fiscal Year 5

Revenues

   Super New Product

$0

$49,500

$180,000

$540,000

$1,320,000

   Training Course

9,996

33,000

43,200

54,600

66,000

   SaaS Software

0

600,000

1,000,008

1,599,996

2,000,004

   Total Revenue

9,996

682,500

1,223,208

2,194,596

3,386,004

 

 

 

 

 

 

Cost of Goods Sold

 

 

 

 

 

   Super New Product

0

31,356

114,948

341,400

834,540

   Training Course

828

2,496

3,000

3,492

3,996

   SaaS Software

0

0

0

0

0

   Total Cost of Goods Sold

828

33,852

117,948

344,892

838,536

Gross Profit

9,168

648,648

1,105,260

1,849,704

2,547,468

 

 

 

 

 

 

Expenses

 

 

 

 

 

   General & Administrative

249,420

260,904

344,004

362,736

383,940

   Manufacturing & Production

63,504

66,672

140,028

147,024

154,368

   Marketing & Sales

24,996

45,396

52,800

60,204

67,596

   Research & Development

381,000

533,400

280,056

294,036

308,736

   Total Expenses

718,920

906,372

816,888

864,000

914,640

EBITDA

(709,752)

(257,724)

288,372

985,704

1,632,828

   Depreciation

8,328

8,328

13,332

26,670

35,004

EBIT

(718,080)

(266,052)

275,040

959,034

1,597,824

   Interest

0

0

0

0

0

   Provision for Income Taxes

0

0

0

62,486

399,456

Earnings After Tax (EAT)

($718,080)

($266,052)

$275,040

$896,548

$1,198,368

 

 

 

 

 

 

             Cum Net

($718,080)

($984,132)

($709,092)

$187,456

$1,385,824

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE or paperback format http://www.amazon.com/Will-Your-Start-Make-Money/dp/0996028307 

Using Assumptions for Pivoting in Lean Startups

Using Assumptions for Intelligent Pivoting

In an earlier blog post, I talked about the types of key business assumptions that you want to define as part of your business planning (see https://www.offtoa.com/wp/?p=218). However, as shown in the figure below, those assumptions play just as critical a role for you once you launch the company. Here’s why. As you lead your company, you will at the same time be verifying the validity of your assumptions. In some cases you will do this in response to an explicitly designed experiment (as suggested by Eric Ries in The Lean Startup). In other cases you will do this as the result of simply running the business. Regardless of origin, every time you determine a correct value for a key assumption, the risk associated with your company decreases. However, when you refute a key assumption, an alternative plan of action is called for. Before we explore what these actions might look like, let’s take a quick look at some examples of what refuting an assumption might look like:

Refuting an Assumption

  • You build an minimal viable product (MVP). You learn more about what the market really needs. This changes the number of units you expect to sell.
  • While interacting with potential customers, you learn about a target market you had not previously envisaged that needs your product even more than the market you originally were aiming for. This causes you to redefine your original market as your secondary market, and define the new market as your primary market.
  • You had originally guessed that customers would be willing to pay $5 for your product. You ran some experiments offering the product at $4, $5, and $7 to three geographic regions. In all three cases, 5% of those receiving an advertising email from you ended up purchasing. Therefore, you have decided that $7 will work as well as $5.
  • Your product development effort took 2 months longer than expected. You may need to lower your burn rate (by changing the number of employees) and add an additional investment round.
  • Your first year product demand far exceeds your wildest dreams. You cannot just enjoy the ride. Instead you need to build infrastructure, hire employees, purchase raw materials, and on and on, all in a manner that keeps your cash positive. The only way to do that is by changing many of the assumptions and verifying that you are still heading for financial success.

Plan Perform Pivot

Plan Perform Pivot (click to enlarge)

At first glance, the situation in each of the above cases looks different, but your response should be identical. Although Ries defines eight types of pivots in The Lean Startup, they are all just instances of the same general pivot process, as shown in the Pivot box in the above figure:

  1. Change the key assumption that you just refuted.
  2. Analyze the pro forma financials to see if the company’s future is still financially sound (it likely will not be).
  3. Alter other assumptions to accommodate until you are back on the right path.
  4. Redirect the company toward the new strategy, i.e., the strategy defined by the newly defined assumptions.

Pivot Types

Here is a summary of Ries’ eight specific pivot instances and how they affect assumptions:

  1. Zoom-in pivot. After use by customers, we learn that a subset of features is a more ideal product for the customer than the full product. Immediate changes to assumptions are:
    • Name of the product might change.
    • Price of the product might change. It might be lower because the product is smaller, or it might be higher because the product is better targeted to a customer pain.

Once the decision is made to focus the product, we need to maintain consistency across all assumptions, and thus we should adjust:

    • Units sold should remain the same or increase. One’s initial reaction might be to lower expectations because of a smaller product, but more than likely the reason we decided to zoom in is because customers want this smaller product more than they want the broader product. As a result, the product is better targeted to market needs and the marketing organization can focus its campaign on more specific pains. Thus, units sold likely would increase, not decrease.
  1. Zoom-out pivot. After use by customers, we learn that features we are providing are insufficient to sustain the customer base and we must expand features considerably. Immediate changes to assumptions are:
    • Name of the product might change.
    • Price of the product might change.

 Once the decision is made to expand the product, we need to maintain consistency across all assumptions, and thus we should adjust:

    • Units sold should remain the same or increase. More than likely the reason we decided to expand the product is because customers were not interested in buying the product in quantities we had originally envisioned. By expan­ding the product, it is better targeted to market needs and marketing can focus its campaign on more generalized pains. Although we would like units sold to increase, in most cases where I have seen zoom-out pivots, it has been to get “back on track,” so units sold often decrease, at least in the short term.
  1. Customer segment pivot. We learn that we want to target a new market either because (a) we were targeting the wrong market, or (b) we want to now expand the market. The immediate changes to assumptions are:
    • Name(s) of the market will change.
    • Size(s) of the market will change.
    • Growth rate(s) of the market will change.
    • Price of the product might change because this new market might feel the pain differently or may have different economics. 

Once the decision is made to retarget the product to a new market, we need to maintain consistency across all assumptions, and thus we should adjust:

    •  Units sold should remain the same or increase. The most likely reason we decided to redirect the product toward a new market is because we found a market containing customers who were more excited (or as excited) as our current target markets. On the other hand, the customer segment pivot could also be a down-pivot from an originally targeted market that was not meeting our expectations to another market that we expect to perform better but still not meet our original assumptions . . . in which case our new units sold assumptions would actually decrease.
  1. Customer need pivot. We learn that customers in our target market have a pain, our current product does not address it, but we could build a business based on a new product. This likely requires an entirely new financial model with a new set of assump­tions; perhaps the characteristics of the market are salvageable. Based on the specifics of the business and the pivot, some other parts of the financial model could be salvageable, e.g., the loans and investments might be; the sales model might be.
  2. Platform pivot. Ries differentiates between two kinds of products: those that are sold to end users vs. products that are sold to companies (or other intermediaries) who tailor your product or build atop your product to create products for end users. The pivot is changing from either one to the other. From a business perspective, we believe it is just a specialized case of a customer segment pivot. The platform pivot is simply one techno­logy-specific way to reposition a product or refine a product’s features in response to the recognition that a particular target market (in this case, platform tailors or application builders) have a need for a different product.
  3. Business architecture pivot. Many dozens of basic strategies exist for start-ups to follow; these include product strategies (see blog post https://www.offtoa.com/wp/?p=164), pricing strategies (see blog post https://www.offtoa.com/wp/?p=213),  personnel strategies (see blog post https://www.offtoa.com/wp/?p=192), target market strategies (see blog post https://www.offtoa.com/wp/?p=176), and so on (see blog post https://www.offtoa.com/wp/?p=158). What Ries calls a business architecture pivot is what most business leaders call a “change in basic corporate strategy,” so we would prefer to call it something like a corporate strategy pivot. Although Ries discusses only size of market and margin, our past blogs have pointed out that strategy spans every aspect of a business. And thus the deci­sion to execute this type of pivot could affect all assumptions drastically. The most important consideration when performing this pivot is to ensure that all assumptions remain consistent with the new strategic direction; very few will remain unchanged.
  4. Engine of growth pivot.  Fundamental to the philosophy of The Lean Startup is the notion of maintaining a sustainable engine of growth while running the business. In essence, this means that the company can grow organically, from actions performed by current customers. Ries isolates the three basic ways for a start-up to sustain its growth: viral (see blog post https://www.offtoa.com/wp/?p=185), sticky (see blog post https://www.offtoa.com/wp/?p=182) and paid (see blog post https://www.offtoa.com/wp/?p=179).  

Although Ries seems to stress that successful start-ups emphasize just one engine of growth, and of course the most famous billion dollar e-business success stories have emphasized just one engine, our experience has been that most successful start-ups use a combination of paid and sticky or paid and viral to sustain their growth.

As an entrepreneur, you execute an engine of growth pivot when your current engines of growth are not providing you with sufficient growth to achieve your goals, or when other engines of growth will provide you with even better growth. To execute this pivot, you change the way it will grow (and the way it will measure its growth) from a combination of these 3 ways to another. The immediate change to assumptions is:

    • If changing to a primarily viral growth engine, you would focus your corporate energies on implementing the viral spread of the product and you would focus your goal-setting on the following sales model assumptions: viral coefficient and length of viral cycle.
    • If changing to a primarily sticky growth engine, you would focus your corporate energies on retaining customers and you would focus your goal-setting on the following sales model assumptions: average order size and annual retention rate.
    • If changing to a primarily paid growth engine, you would focus your corporate energies on attracting new customers at the lowest cost per customer and you would focus your goal-setting on the following sales model assumptions: customer acquisition cost, sales cycle, ratio of dollars spent to units sold, ratio of employees to units sold, and ramp up.
  1. Channel pivot.  Ries describes a channel pivot as changing the mechanism used to reach the end user, e.g., selling direct to end users vs. using a distributor vs. using a whole­saler. In our experience here at Offtoa, every sale involves multiple levels of “customers.” Every sale must accommodate needs of individuals who pay the check, who physically use the product, who need information produced by the product, who acquire (whether pur­chased or not) the product from individuals who pay for it. The decision to sell your product to a wholesaler vs. distributor vs. retailer vs. the end user is both fundamental to strategy and nontrivial; but it is identical to the decision to sell to one target market vs. another. Thus, we consider a channel pivot to be just a specialized case of a customer segment pivot.

Start-ups can detect the invalidity of any assumption, not only the ones implied by the above eight. Although we prefer the concept of a generalized pivot, you may prefer to assign names to specific types of pivots. If so, we offer the following list (this is just a small sample of the possibilities). These are all easily derivable be simply assigning a name to the refutation of each assumption:

  1. Renegotiate payment terms pivot. This pivot is executed upon either of two events: either we discover that customers are not paying us as quickly (or as slowly) as we had planned, or we take the initiative to renegotiate payment terms with our suppliers. The immediate changes to assumptions are:
    • Customer payments to you will change.
    • Your payments to vendors/suppliers will change.
  1. Financing pivot. When we initially plan a company, we have expectations for certain cash needs and where that cash will come from. Typically it is some combination of loans and investments for certain amounts at certain times. Many events occur that make reality different than the plan: we spend more (or less) than anticipated, our revenues exceed (or fall short of) plan, an investment round is not completely sold, a bank does not approve the full amount of a loan, and on and on. Whenever any of these events occur, we must pivot; we must replan our company and devise a new strategy that enables the company to reach its next milestone on existing resources, or, alternatively, accelerate the next cash infusion step. The immediate changes to assumptions are a subset of:
    • Expenses should change if expenses differ from plan.
    • Units sold should change if revenues differ from plan.
    • Investment amount if investment round fell short.
    • Loan amount if lower than anticipated.
  1. Price pivot. We determine we have the right product for the right market, but the price point is wrong.
  2. Sales cycle pivot. We determine we have the right product for the right market, at the right price but it takes 90 days to convert a lead into a customer instead of the anticipated 30 days.
  3. And so on 

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE or paperback format http://www.amazon.com/Will-Your-Start-Make-Money/dp/0996028307 

How Reducing Costs Can Impact Pricing

Reducing Costs Provides Opportunities

Let us assume that your start-up has figured out some way of reducing its costs below the competition. It might have done so through finding cheaper sources of raw materials (thus lowering costs of goods sold), or reducing process steps, or using proprietary technology, or using cheaper labor, or whatever. Once accomplished, you now have two sub-strategies to consider:

Lower Costs Can Mean Lower Prices

  • Sub-Strategy 1: Passing Reduced Costs on to Customers: You leverage your unique capability and turn it into lower prices for customers, thus achieving higher market penetration. This is a particularly good sub-strategy to utilize when cost savings does not also result in a better pro­duct in the eyes of customers. Now, when customers compare your product and a competitor’s product side-by-side, they will see two products that provide relatively equivalent performance but your product will be less pricey, and thus will provide more value.

Lower Costs Can Mean Higher Margins

  • Sub-Strategy 2: Converting Reduced Costs into Higher Margins: You main­tain prices comparable to competition, but because your costs are lower, you achieve higher profit than competition. With higher profits, your company will command higher valuation, and you can retain those profits, reinvest them in R&D, further enhance your processes, and thus drive down your costs even further.

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE or paperback format http://www.amazon.com/Will-Your-Start-Make-Money/dp/0996028307 

How to read a cash flow statement for a startup

How to read a cash flow statement

When you plan a start-up company, you will need to create pro forma financial statements, including the income statement, cash flow statement and balance sheet. A pro forma cash flow statement shows all cash that you expect will come into the company and all cash that you expect will go out of the company during a period of time based on your stated assumptions. Let’s say, for example, that we want to look at your company’s first year’s cash flow statement. Then, the period of time is the “first year.” The figure below shows a cash flow statement for the first five years of a company. All cash flow statements are organized into three horizontal sections, each corresponding to a different set of events that cause cash to flow into or out of the company, as shown in the figure:

Cash from operating activities

Cash that relates to your primary business. This is called cash from operating activities. The first entry here is the profit or loss from the business (copied right from the bottom of the income statement). The rest of the entries are adjustments because not all profits or losses are manifested in cash. So, for example,

  • Depreciation was shown on the income statement and contributed to expenses (and thus a decrease in profit), but unlike other expenses, it incurred no corresponding reduction to cash. Therefore the first thing we do on the cash flow statement is add back in the amount of depreciation as positive cash.
  • Any decrease (or increase) in accounts receivable between the last period and the current period must be reported here as an increase (or decrease) in cash. Notice that if customers pay you during the current month for something that they purchased in a previous month, no entry is made on the income statement, but you did have a positive cash event. That cash event is recorded on this line.
  • Any increase (or decrease) in accounts payable must be added to (or subtracted from) the cash from operating activities on the cash flow statement for the same reason as explained above for accounts receivable.
  • If there is any change in the accrued liabilities between the last period and the current period, that change needs to be added to or subtracted from cash on the cash flow statement.
  • Any changes to inventory would not be reflected in your income statement but would affect cash. Specifically, if you increased your inventory since the previous period, that needs to be reflected as a net cash loss, and a decrease would be reflected as a net cash gain.

The sum of the above items is shown as the net cash provided (used) by operating activities.

Cash from investing activities

Cash that relates to your major purchases (or sales) of fixed assets (e.g., real estate, equipment, vehicles, computers, and so on.) This is called cash from investing activities. Notice that although such major purchases cannot be subtracted from your earnings in the current year (that’s why they don’t appear on your income statement), they do impact cash! The full amount of their purchases is recorded here because the company is incurring the entire cost of the asset from a cash perspective. Their sum is shown as the net cash provided (used) by investing activities.

Cash from financing activities

Cash that relates to financing your business, e.g., loans you accept (or make payments on) and investments received or stock repurchases made by the company. This is called cash from financing activities, and is shown on two separate lines, one for investments, and one for loans. Notice that loans and investments you accept have no effect on your income statement but have a significant effect on your cash . . . which is why they appear here! Their sum is shown as the net cash provided (used) by financing activities.

Summary lines on cash flow statement

At the bottom of each column appear a few summary lines:

  • The net increase (decrease) in cash line shows the sum of the net cash subtotals from the three aforementioned sections.
  • The cash at beginning of period starts at zero when the company is founded. Each subsequent year just copies the value from the end of the previous year.
  • The cash at end of period is calculated by adding the net increase (decrease) in cash to the cash at beginning of period.  A quick check should be performed to make sure that this value equals the top line (i.e., cash and cash equivalents) of the balance sheet. Make sure you are comparing a cash flow statement that ends on the same date as the date of the balance sheet.

Pro Forma Cash Flow Statement for NewCo, Inc. 

 

 

 

 

 

 

 

 

 

 

Fiscal Year 1

Fiscal Year 2

Fiscal Year 3

Fiscal Year 4

Fiscal Year 5

CASH FLOWS FROM OPERATING ACTIVITIES 

 

 

 

 

 

   Net (loss) profit

($718,080)

($266,052)

$275,040

$896,548

$1,198,368

   Adjustments to reconcile net cash used by operating activities:

 

 

 

 

 

      Depreciation

8,328

8,328

13,332

26,670

35,004

      Income Tax

 

 

 

 

 

   Changes in operating assets and liabilities:

 

 

 

 

 

      Accounts receivable

(833)

(56,042)

(85,000)

(80,949)

(99,284)

      Accounts payable

8,402

4,615

7,881

19,925

42,295

      Accrued liabilities

52,917

13,758

(8,330)

2,913

3,062

      Inventory

(26,577)

(11,680)

(31,520)

(68,561)

(233,537)

   Net Cash Provided (Used) by Operating Activities

($675,843)

($307,073)

$171,403

$796,546

$945,908

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES 

 

 

 

 

 

   (Purchase or) sale of fixed assets

(50,000)

0

(30,000)

(100,000)

0

   Net Cash Provided (Used) by Investing Activities

(50,000)

0

(30,000)

(100,000)

0

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES 

 

 

 

 

 

   Issuance of stock

830,000

465,000

0

0

0

   Proceeds from (payments on) notes payable

0

0

0

0

0

   Net Cash Provided (Used) by Financing Activities

830,000

465,000

0

0

0

 

 

 

 

 

 

Net Increase (Decrease) in Cash

104,157

157,927

141,403

696,546

945,908

 

 

 

 

 

 

Cash at Beginning of Period

0

104,157

262,084

403,487

1,100,033

Cash at End of Period

104,157

262,084

403,487

1,100,033

2,045,941

 

 

 

 

 

 

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE or paperback format http://www.amazon.com/Will-Your-Start-Make-Money/dp/0996028307 

How Much Money Should You Ask Investors For?

How Much Investment Cash?

New entrepreneurs regularly ask me how much capital they should ask for when they approach investors. It turns out that this is a relatively simple question to answer, and one I will address here. The simple answer is: as much as you need plus a cushion. Here is how you determine how much you need:

Step 1: Create Your Income Statement

Based on your assumptions concerning pricing, marketing and sales methods, costs, and expected sales volumes, create monthly income statements. If you don’t know how to do this, Offtoa™ is a tool that asks simple questions about your business and creates your monthly income statements for you . . . in the same way that Intuit’s TurboTax® asks simple questions about your income and deductions and creates your tax return.

Step 2: Create Your Cash Flow Statement

Based on additional assumptions concerning how quickly customers will pay you and a few other factors, create monthly cash flow statements. Once again, if you don’t know how to do this, Offtoa can create your monthly cash flow statements for you.

Step 3: Look at the Low Point on Your Monthly Cash Flow Statement

Examine the cash balance at end of the month at the bottom of each column on your monthly cash flow statement to find the month where this value dips the farthest below zero. You will need to raise this much money before this date to stay solvent.

Step 4: Add A Cushion

Since nothing will go exactly as planned (e.g., revenues will be lower, the sales cycle will be longer, expenses will be higher, and so on), add a cushion so you don’t run out of money or have to ask for more.

Step 5: Timing

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. A good solution in many cases is to plan for a series of investment rounds, each one at a successively higher price per share, and each one timed to ensure that the company does not run out of cash before the following round.

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle or paperback format at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE

Determining Future Valuation of a Startup

Future Valuation

My previous blog post (https://www.offtoa.com/wp/?p=237) described why an entrepreneur needs to determine today the likely valuation of the startup company at  some point in the future. That’s what I will discuss in this post.

How to value?

Let’s assume you predict the company will be acquired in 5 years. You stated all your assump­­tions about your business strategy and transformed them into pro forma income state­ments, balance sheets, and cash flow statements for the next 5 years. You now have enough data to make an educated guess about the value of the company based on other companies who have had liquidity events with similar financials. Of course, there are many problems with such a valuation:

  1. Your assumptions are just assumptions, not facts. In fact, some of them are just guesses. That is why you need to use as many sources as possible to validate your assump­tions. That is why you should show your assumptions (not just your financial statements) to potential investors; let them question the assumptions (and revise as necessary).
  2. Many factors influence the value of a company besides just its financials. Such intangibles relate to the market, the economy, intellectual property, state of competitors, the level of merger & acquisition activity in your industry, the “hotness” of your industry sector [1], and so on.
  3. We will be valuing your company based on multiplying various elements of your pro forma financial statements by multiples specific to your industry. However, the values of these multiples change over time. A big change in the public stock markets will cause a big change to the values that should be used for the multiples for your industry.

To value your company at the end of the fifth year, do the following

  • Take the annual revenue for year 5 (aka “trailing revenue”) and multiply it by the industry revenue multiple. The industry revenue multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual revenues. (b) Look up the average P/S (Price/Sales) ratio for the industry on any finan­cial website; this will give you a high valuation because publicly traded stocks are more liquid (and thus more valuable) than private stocks.
  • Take the annual gross profits for the 5th year (aka “trailing gross profits”) and multiply it by the industry gross profits multiple. The industry gross profits multiple is computed in one of the following ways: (a) Look at the last n acqui­sitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual gross profits. (b) Look up the average P/S ratio for the industry on any financial website; divide it by the average gross profit margin for the industry; this will give you a high valuation because publicly traded stocks are more liquid (and thus more valuable) than private stocks.
  • Take the annual EBITDA for the 5th year (aka “trailing EBITDA”) and multiply it by the industry EBITDA multiple. The industry EBITDA multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual EBITDA. (b) Look up the average P/S ratio for the industry on any financial website; divide it by the average EBITDA/sales ratio for the industry; this will give you a high valuation because publicly traded stocks are more liquid (and thus more valuable) than private stocks.
  • Take the annual EBIT for the 5th year and multiply it by the industry EBIT multiple. The industry EBIT multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual EBIT. (b) Look up the average P/S ratio for the industry on any financial website; divide it by the average EBIT/sales ratio for the industry; this will give you a high valuation because public stocks are more liquid than private stocks.
  • Take the annual earnings after tax for the 5th year (aka “trailing profits”) and multiply it by the industry profits multiple. The industry profits multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual EAT. (b) Look up the average P/E (Price/Earnings) ratio for the industry on any financial website; this will give you a high valuation because public stocks are more liquid than private stocks.
  • Compute the average of the above five averages. This will give you as accurate an estimate as you can compute for the valuation of the company . . . given the three caveats above

What to do with that future valuation?

Let’s assume that you follow the procedure described above and you determine that the company will be worth, say, $20,000,000 in 5 years. What good is that knowledge? The answer is: You can use it to determine what percent ownership of the company today will be worth in 5 years. Continuing with this example, if you have determined that the company will have a value of $20,000,000 in 5 years, then a 25% stake will have a value in 5 years of $5,000,000. Therefore, if you offer an investor a 25% stake in the company today for, say, $1,000,000, you are

  • Explicitly stating that the company is worth (today) $4,000,000, which you will have to justify!
  • Implicitly (via your financial statements) stating that the $1,000,000 investment can create a $5,000,000 return if all the assumptions become reality, and the company has a liquidity event in five years at the valuation multiples that are currently being assumed. The IRR for that $1M investment becoming $5M in 5 years, by the way, is 38%.

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle or paperback format at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE. By the way, Offtoa.com does future valuation automatically for you based on your answers to a few simple questions.



[1] According to Mark Andreessen (http://techcrunch.com/2013/01/27/marc-andreessen-on-the-future-of-the-enterprise), valuations can vary by as much as fourfold based on the hotness of the sector.

[2] Inc. Magazine occasionally publishes this data on their website at www.inc.com. The latest data is available by subscription from Hoover’s at www.hoovers.com.

 

Startup Valuation

What is Valuation?

The term valuation means to determine what something is worth, i.e., to assign something a value. In the case of a startup company, the value of the company at its very beginning, at the moment that somebody thinks of an idea, is pretty easy to determine; it is very close to zero. As the company evolves, as it reaches each significant milestone, it becomes more and more valuable.

Why value?

There are two good reasons why we want to value a company.

  • The first is to determine a price at which a part of the company should be sold. Say, for example, you have determined that the company needs to raise $1,000,000 now in order to reach its next significant milestone. The big question is: should you sell 10% of the company for $1,000,000? Or 25%? Or 50%? Or 75%? The answer should not be made in arbitrarily. If you decide on 10%, you are declaring that the company is worth $10,000,000; after all, if 10% is worth $1,000,000, the entire company must be worth $10,000,000. If you want to make such an offer, you must be able to justify that the entire company is worth $10,000,000. By the same logic, if you decide on 25%, you are declaring that the company is worth $4,000,000. And 50% implies the company is worth $2,000,000. And 75% implies the company is worth $1,333,333. So, having a tool to value a company right now, enables you to determine what percentage of the company you should sell in order to raise the cash you need. For companies with a financial history, this is relatively easy to do, and many books have been written on the subject (e.g., see Koller). However, for startups, there is no financial history, so valuation of this type is extremely difficult.
  • The second is to determine what the company’s value should be in the future. Unlike today’s situation described in the previous bullet in which there is no financial history, a valuation of the company at the time of a predicted future liquidity event can be based on predicted financial results. Now the steps to create a valuation become (a) define a predicted liquidity date, (b) define all your business strategy assumptions (and argue and resolve those arguments), (c) create the company’s pro forma financial statements based on those assumptions, and (d) value the company at the liquidity date based on trailing financials as of that date. My next blog entry will show how this is done.

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle or paperback format at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE. By the way, Offtoa.com does future valuation automatically for you based on your answers to a few simple questions.