Category Archives: Assumptions

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)

Seven Signs your Startup will Succeed

Banded Snake Eagle, Ubuntu, TanzaniaMatthew Toren wrote a terrific article 7 Myths About Starting a Business That I Used to Believe. In it he debunks 7 myths about startups that could otherwise easily deter those with a great idea that don’t know any better. With these myths debunked, let’s talk about the seven signs that indicate your startup will be among the 50% that survive 5 years.

1. You Know Your Competition

Key to a product being successful in the market is that customers see it as a better solution to their pain than alternatives offered by the competition.

Better can be mean lower priced, or more convenient, faster, cleaner, greener, more exclusive, more reliable, and so on. These qualities are called differentiators.

I use the word competition here in the broadest possible sense, including companies that are directly competing with you (e.g., Avis if you are Hertz), companies that are indirectly competing with your company (e.g., bus companies if you are a rental car company), and the status quo (e.g., people who are not traveling because of the lack of transportation options).

2. You Know Your Financials

Lean is the only way to start most companies today, but prudent does not mean blind. Responsible lean companies document all their business assumption so they can run experiments to validate those assumptions and incrementally lower risk. Those same documented assumptions are also sufficient to create pro forma financial statements.

Those financial statements enable you to determine whether the company could succeed if the assumptions prove to be true.

3. You Have Room for Error

Pilots always have enough fuel to return to an airport, and always use a runway longer than is required for their aircraft type. Having room to navigate the unexpected is also crucial for startups because inevitably one, some or even all of these things will happen:

  • Fewer visitors will come to your website
  • Customer acquisition cost will be higher than planned
  • Revenues will be lower than expected
  • Customers won’t pay on time
  • Materials, raw goods, and services will cost more than budgeted

4. Your Sales Are Planned Bottom Up

If you guess at your projected revenues, you are not setting up your startup for success. Instead, determine how you are going to sell. For example:

  • Are you going to drive traffic to your website and then convert x% of the visitors to paying customers?
  • Are you going to make x outgoing sales calls per day, and convert y% of them to paying customers?

See the article, 5 Steps to Get & Keep Your Startup on Track, to learn how to calibrate your revenue projections.

5. Your Experiments Are Planned

After you state your assumptions, run experiments to validate (or refute) them. Either way, you are making progress. Knowledge is always better than guesswork.

For example, run advertisements and perform SEO and see how many actual visitors you can drive to your website. Run A/B tests on various pricing models to see what price attracts customers.

6. You Have an External Board

If you put your co-founders and/or your officers on your board of directors, you will receive zero benefit from them; after all, you’ll hear the same things from them in the board room that you hear every other day.

Instead, fill your board seats with experienced individuals who (a) can offer you different opinions, (b) can bring skills that your current team does not have, (c) are not afraid to question the decisions you are making, and (d) can serve as a totally independent sounding board for you.

This is what a board of directors can do for you. And then compensate them with stock options.

7. You Are Sharing Ownership

Jerry Kaplan said it best: “Equity is like sh*t. If you pile it up, it just smells bad. But if you spread it around, lots of wonderful things grow.” Incent those who contribute to the success of your startup with stock options (or reverse vesting stock), and the company is more likely to grow and prosper. There is little downside, and lots of upside. See You are Not Your Company for more details on this subject.

Summary

Starting a company has inherent risks. But some risks are easy to reduce by planning, validating, refining, pivoting and then doing it all again!

I recently visited JoJo, a young woman in Kigali, Rwanda who started a Jibu water franchise. During my hour-long visit with her, I asked her a dozen or so questions. I was impressed by the fact that although she had little formal business education, she had tons of business common sense, understood what her biggest risks were, knew how to reduce those risks, and understood which levers influenced the success of her franchise.

I have no doubt that she will be one of the long-term survivors. JoJo knows how to make a startup succeed! In her case, she knows her competition, knows her financials, has room for error, knows exactly how she is going to sell water, and is constantly running marketing experiments. Although she does not have an external board of directors, she has surrounded herself with individuals with lots of experience.

If you want to learn how to generate pro forma financial statements automatically from your lean business assumptions, check out www.offtoa.com.

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 atWill 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.

7 Steps to Calibrating Your Startup Growth

640px-Mahr_Micromar_40A_0-25mm_MicrometerWhen you start a company you naturally have two immediate and equally pressing priorities.  Those priorities are to solve a problem for customers and to validate that you can make money solving that problem.

To validate that you can make money and to understand when you’ll make it, you need to build a pro forma income statement. A pro forma income statement shows how much revenue you expect to receive from the sale of your product and what expenses you expect to incur over your first few years of doing business.

Three basic approaches exist to predict startup revenues:

  • You can just guess. But beware!  Nobody will believe the numbers.
  • You can estimate that you will achieve some percentage penetration of the total available market. Sadly, nobody will believe these numbers either.
  • You can determine which processes you will use to achieve sales, estimate how efficient those processes will be, and then derive how much revenue you will achieve based on those assumptions.

This article explains how to do startup revenue estimation using the third approach. It involves the calibration of seven key variables.  You’ll start with the initial estimation of the seven key variables and then refine them as you learn actual values.

The Seven Key Variables:

  1. Customer Acquisition Cost (CAC): For those new customers that you attract as the result of your marketing activities, how much does it cost you per customer? This is one of the most difficult to estimate. You will start with just a guesstimate based on the (very) few published data from other companies in industries similar to yours and using sales techniques similar to yours.
  2. Sales Cycle (SC): How many months transpire between your expenditure of marketing dollars and the acquisition of new customers? This will also be just a guesstimate based on your past experience.
  3. Average Order Size (AOS): How much revenue do you expect to generate each time a customer makes a purchase? You should have a pretty good idea of what you want to achieve here based on your product, pricing, and business model.
  4. Periodicity (P): How often will each customer make a purchase? You should have a pretty good idea of what you want to achieve here based on your product, pricing, and business model.
  5. Retention Rate (RR): What percent of existing customers will remain customers at the end of each year?
  6. Viral Coefficient (VC): How many people will each existing customer attract and successfully convert into new customers? This is a one-time conversion; once a customer refers this many new customers, we assume they no longer refer more new customers. Very few companies achieve a VC as high as 1.0.
  7. Viral Cycle Length (VCL): How many days will transpire between customers becoming new customers and their referrals becoming new customers?

Before you launch your company, verify that the estimates you’ve made for the 7 key growth drivers could result in a successful company. That is, there must be significant revenues and profit, and solid returns for all shareholders to be considered successful. If not, realistically adjust the values until the company shows returns. But don’t just change the values to make the company look like it will be successful; the new values must be achievable!

Refine the Seven Key Variables:

After launch, every month, compare your actuals to your planned values for the 7 key growth drivers. Enter actual values for CAC, SC, AOS, P, RR, VC, and VCL into your plan. It might be helpful to graph each one. You will likely find that

  1. CAC and SC will start off quite large and will only converge to stable (and lower) values after you learn how to find your target market and how to optimize your messaging.
  2. You will not be able to ascertain actual values for RR, VC or VCL until after a year or so.

Verify that the actual values for these 7 key growth drivers still result in a successful company – i.e., significant revenues and profits, and solid returns for all shareholders. If so, you are on track! If not, you need to pivot.

How to Change Actual Values for the Seven Key Variables:

  • To decrease CAC and SC: Improve your understanding of the target market. Hone your advertisements to the specific pains of your target markets. Focus on benefits rather than features of your products. Offer better pricing or better promotions to increase close rates.
  • To increase AOS: Offer quantity discounts. Improve your product.
  • To increase P: Offer frequent buyer programs. Improve your product.
  • To increase RR: Improve your product’s stickiness.
  • To increase VC and decrease VCL: Offer referral programs, especially ones that incent both referrer and new customer. Make products so exciting that they create a buzz. Add features that increase your product’s value to customers.

Summary:

As you can see, these seven key variables are fundamental to understanding your startup’s revenue. They are not easy to estimate, but you can at least determine during the planning stage what values you must achieve to be a viable company.

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, sign up for www.offtoa.com.

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.

Auto Comfort Compressed

Seven Steps to Starting a Startup

Step 1. Do Some Homework

If you try to know everything about your industry and market before you start your company, you will never launch it. Instead, learn the most important aspects of the market and the competitors.

Start with the great checklist of things you should try and learn about your market and industry from Mullins’s book, The New Business Road Test: What Entrepreneurs and Executives Should Do Before Launching a Lean Start-Up, but concentrate on looking for showstoppers, i.e., reasons why you perhaps should not start the company.

Step 2. State Your Business Idea as a Set of Assumptions

Since you cannot possibly know everything about the market and the industry, record all assumptions you are making about your business. What products will you sell? At what price? How large is your market? How many will you sell each year? How much will it cost you to purchase and/or manufacture the product? How many employees will you need? How much will you pay them? And on and on.

There are dozens of such assumptions. You can find a checklist at What Assumptions Does an Entrepreneur Make?  Many reasons exist to record these assumptions:

  • It forces you to think through every aspect of your business idea. You don’t want to be 6 months into a business and say “Oh, I wish I had thought of that earlier!”
  • The numeric assumptions can drive the creation of all your pro forma financial state­ments, which you will need anyway.
  • You can assign a red flag to each assumption that is not yet confirmed. Remove flags as assumptions are confirmed.
  • Assumptions that are critical to your success and still have red flags become targets for experiments. Build and deploy prototypes, run focus groups, do anything it takes to find out as early as possible if those assumptions are true or not

Step 3. Determine if Your Business Idea is Financially Sound

Pro forma financial statements enable you (and others) to easily assess the expected financial health of a company. As a result, they are extremely useful in assessing the likely outcome of a company if all your assumptions prove to be true.

So the next step is to transform your assumptions into financial statements and confirm that the company makes financial sense. Some of the checks you want to perform are:

  • When is it profitable?
  • How much cash does it need to get started?
  • Does it grow fast enough?
  • When is breakeven?
  • How much of a return do investors make?

Step 4. Refine the Assumptions

If the financial statements fail any of your checks, you need to decide how critical the failure is. For each check, you can change your business assumption, or you may have good reasons to ignore the alleged problem. If so, make sure you fully understand your rationale and can articulate it because investors and other stakeholders will ask you about it.

Step 5. Launch and Run the Business

As you start to run your company, you will discover that some assumptions you made during the planning stage will prove to be false and you will need to make adjustments. If you are smart, you will actually run myriad experiments with your customers to explicitly prove or refute the most crucial assumptions.

Step 6. Change Refuted Assumption and Determine if Your Business Idea is Still Financially Sound

Whenever you determine that a stated assumption is no longer valid, change that assumption based on what you just learned. Next check that the company is still on solid financial ground using the same techniques you used in Step 3.

If so, continue on the current path.

Step 7. Pivot when Necessary

If not, revise other assumptions to compensate for the new reality. Verify that this makes financial sense using the techniques you used in Step 3, and then manage your company in the new direction as defined by the new assumptions. This is called a pivot.

Summary

The odds of success for a startup are very low.  Improve your chances by diligently planning and being ready to adapt when new information emerges.  These 7 steps will help you balance both.

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.

wordle

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.