Category Archives: Capitalization

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

Liquidation Preference and Avoiding Dilution

For me, as an early investor, straight dilution is not a scary thing. Since I have no interest in “control,” owning 10% of a $1,000,000 company is identical to owning 2% of a $5,000,000 company. What scares me as an early investor is the idea of later investors demanding liquidation preferences greater than 1x. When they get such preferences, they end up taking more than their fair share, and squeezing out the earlier investors down to zero ownership. Here is an example:

  • Let’s assume 1,000,000 shares currently exist.
  • We invest $250,000 (let’s call it Series A) and acquire 20% of the company with a pre-money valuation of $750,000 (post-money valuation of $1,000,000). We’ll be purchasing 250,000 shares at $1/share. Let’s assume we negotiate 1x liquidation preferences.
  • At the next round (let’s call it Series B) one year later, the company has a pre-money valuation of $3,200,000 (post-money valuation of $4,000,000), and other investors invest $1,000,000 to purchase 20% of the company with 2.5x liquidation preferences. They’ll be purchasing 312,500 shares at $3.20/share. We decide to not invest.
  • If the company is acquired with a huge windfall, everybody will be thrilled, but let’s say the company gets acquired for $4,312,500 after 2 more years. The first thing that happens is we (the Series A investors) get $250,000 and the Series B investors get $2.5M. Next, the remaining $1,562,500 gets divided on a pro rata basis among all shareholders. There are currently 1,562,500 outstanding shares, so each receives $1.00 per share. Thus founders receive $1,000,000 (i.e., $1.00 x 1,000,000 shares). We receive $500,000 (i.e., $250,000 preference, plus $1.00 x 250,000). The Series B investors receive $2,812,500 ($2,500,000 preference, plus $1.00 x 312,500). 
  • As you see, that liquidation preference really screwed the earlier investors. The Series A investors received just a 19% IRR while the Series B investors received a 41% IRR even though the Series B investors presumably took a much lower risk having invested later in the company’s life.

So, bottom line is, dilution is not a fear. Liquidation preferences by future investors who demand high liquidation multiples is a great fear. Just my two cents.