Category Archives: Investors

Even Monkeys Fall From Trees

Black-chinned_emperor_tamarin_(S._i._imperator)Saru mo ki kara ichinru . . . Japanese proverb

I was fortunate. The first startup I joined went public.

The second startup I joined was acquired by a publicly traded company in an all-cash deal with a 3x multiple of the investments.

My third startup failed.

Most serial entrepreneurs fail a few times before they succeed. In contrast, I succeeded a few times before I failed. Even monkeys fall from trees.

I’ve spent much effort studying that failure, trying to determine the precise mistakes that were made during the four years of that company’s life. Some of that study has been productive and a great learning experience; resulting in much improved entrepreneurial practices. I’ve been able to apply many of these lessons to startups #4 and #5.

And I must admit some of that study has been totally counter-productive, in effect self-flagellating. The fact is even monkeys fall from trees.

I published an article a few years ago containing a detailed post mortem of the failure (see Davis, A., and A. Zweig, “The Rise and Fall of a Software Startup,” Journal of Information Technology Case Studies and Applications, 7, 2 (2005)), but I thought I’d summarize the primary lessons learned:

Lessons Learned:

  1. Get Marketing Involved on Day #1. Lesson learned! For some strange reason (probably arrogance), we waited 6 months to get marketing involved in startup #3. What a mistake!
  2. Missionary Sales are Bad News. If the pain you are addressing is not one of the primary pains felt by your target customer, your customer acquisition cost will be huge. Our startup #3 suffered from missionary sales throughout.
  3. Sell a Simple Product Before a Complex One. Although this is how I expressed the lesson back in 2004, we all know now the value of a series of minimally viable products. Unfortunately we learned this lesson the hard way.We spent $1M building our first product, only to discover it was the wrong product. By the time we built a much smaller product and started learning from it, investor confidence had waned and the economy had crashed.
  4. Don’t Get Lured into Fancy Offices. We signed a 5-year lease for Class A office space. Not smart in retrospect. Felt right at the time. After all, everybody was doing it. In general, don’t spend money unnecessarily.
  5. When Accepting Investments, Get More than You Need. This was the subject of an earlier blog. Check out When Should You Ask for Investments?
  6. Be Careful When Partnering with Friends. In startup #3, I partnered with two of my best friends. At the end of the company, one relationship became cemented as a lifelong friend, based in part on having been in the battlefield together; the other disintegrated and I have not talked with him since.
  7. Avoid Bad Economies. This is meant to be tongue-in-cheek. Our company lasted four years from 1998 to 2002, during which a huge number of startup companies were destroyed in the unraveling economy. It would be very easy to simply blame the economy for our woes. It is much more useful to analyze decisions that are under management control.
  8. Keep Your Stakeholders Informed. This is one we did right at startup #3. With only a few exceptions, I’m still in good standing with the investors and former employees of startup #3. Many have invested in and come to work for companies I’ve started since.
  9. Every Employee Deserves Ownership. This is another one we did right at startup #3, and I continue to practice at all the startups I’ve been involved with since. I generally allocate a third of the company’s equity for the option plan, considerably more than most mentors recommend. But this fits well with my management style.Many years ago, my first mentor, Ed Bersoff, made the statement, “I expect to become wealthy as a side-effect of doing great things in this company. I would be extremely happy if many others became wealthy around me as well.” Thank you, Ed, for teaching me this!
  10. Principals Should Invest in Every Round. This is another one we did right at startup #3, and I continue to practice at all the startups I’ve been involved with since. Being the first to invest in every round has two great side effects: (a) when potential investors ask if you have skin in the game, you can answer yes, and (b) when potential investors ask if you’ve raised any money in the round yet, you can answer yes.

But even if you learn all your lessons, and you do everything right, you still may not succeed. And that’s okay. Just pick yourself up, and try again. Remember, even monkeys fall from trees.

ABOUT THE AUTHOR:

Black-chinned_emperor_tamarin_(S._i._imperator)??????????????????????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.

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

Photo of Black Chinned Emperor Tamarin by Kevin Barret (Creative Commons)

To Plan or not to Plan: That is the Question!

SignsI have been an executive in startups since the mid-1980’s, and still am. I have always proactively planned every business in detail, but the last “business plan” document per se I wrote was in 2001. How is this possible?

I want to address some basic questions:

  • What is the difference between planning a business and writing a business plan?
  • What should you include in your planning?
  • In what format should you document your plan?
  • How much detail? What is the right time horizon for business planning?
  • Why do you need to plan your business?

What is the difference between planning a business and writing a business plan?

A business plan is a polished, organized, physical document that describes every aspect of your proposed business and its environment. It usually cover 5-7 years from inception, ramp-up, through to exit. Although occasionally requested by investors, these days it is usually requested only by academics in “business plan competitions.”

Business planning, on the other hand, is the activity of lowering your risk by studying and understanding every aspect of your proposed business and its environment.

What should you include in your planning?

At a minimum, you need to thoroughly understand:

  • The macro market, that is, demographics of the general market you are aiming for. If you are creating a fast food restaurant for diabetics, how many diabetics are there? And are their numbers growing or shrinking?If you are creating a company to provide assistance to early-age retirees, how many individuals are retiring early? And are their numbers growing or shrinking?When tracking dimensions of a macro market, you could measure it in terms of number of customers, number of dollars spent for products like yours per year, or number of products like yours sold per year.

    Great demographics for your macro market are helpful to the success of your start-up. However they are neither necessary (after all, Starbucks succeeded quite well in its North America expansion efforts in the early 1990’s even without a dramatic increase in the number of coffee drinkers) nor sufficient (even terrific growth of a market cannot compensate for sheer management incompetence).

  • The micro market. As an entrepreneur, you need to focus on a specific target market that you can penetrate successfully. By aiming for a specific (usually narrow) target market, you can create a marketing campaign aimed directly at that market and its unique pains.Members of that market then quickly see how your solution addresses their pains and become easy converts and thus customers. On the other hand, if you aim for a more general market, your marketing campaign will have to address more general pains by necessity, and will then be successful at converting a lower percentage of leads. You want all odds in your favor when you start a company.Meanwhile, start with just one target market; if you start with two, you’ll double your marketing costs (or you’ll halve the effectiveness of your marketing by watering down the message).

    The research you need to do concerning possible micro (aka target) markets includes characteristics such as size, growth rate, accessibility (i.e., how easily can you find potential customers?), ease of conversion (i.e., do potential customers “feel the pain” vs. do you have to first convince them that they have a pain? how easily can you convince them that your solution to their pain is by far the best solution available?), and so on.

    As a general rule, having an unfavorable micro market is considered by most experts to be a showstopper. If your target market is not already focused on trying to solve the problem that your product solves, you are fighting an uphill battle.

  • Your competition. Almost every prospective entrepreneur I have come across understands the need to identify “the competition,” but many limit themselves to direct competition, i.e., those companies providing products similar to the start-up’s, which address the market’s needs in a similar fashion.Don’t ignore substitute competition, which customers can choose to address their need in an entirely different fashion. For example, in the electronic note taking industry, over 200 small companies compete with 2-3 very large companies for customers. They are all direct competitors.But this industry suffers from substitute competition from at least two sources: (a) pen and paper, and (b) standard word processors on tablets. Business planning for a start-up in the electronic note taking industry must acknowledge the reality that a very large percentage of the total available market will not be purchasing any company’s electronic note taking software product.
  • Threat of entry. Ideally, (a) you want it to be easy for your start-up to enter the industry, and then (b) once you enter, you want it to be incredibly difficult for others to enter and subsequently compete against you.Concerning point b, when planning your business strategy, what can you do now to make it more difficult for others to copy you? For example, do you have intellectual property that you can protect with patents, copyrights, trademarks, and trade secrets?Can you enter the market quickly enough so that your large market penetration deters others?

    Can you establish contractual relationships with either suppliers or distributors that make it impossible for them to work with competitors?

    Can you provide such good service that no customer would want to change to a competitor?

  • Your Differentiators. What makes you special? Why is your product better than the competition? Saying that you will have a “better user interface” will not cut it; everybody says that. What specific value does your product provide that the market will appreciate and that the competition does not already provide?Here are some examples:
    • We are the only e-tailer that provides restaurant chef-quality gourmet ingredients to the home chef.
    • We are the only manufacturer of a catheter that C4-C5 quadriplegics can use for self-catheterization.
    • We enable online purchasers to donate to their favorite non-profit at no cost to them.
    • We deliver products to your door using drones within 4-hours of ordering.
    • We provide Wal-Mart prices without the long check-out lines.
  • Your Marketing and Sales Strategy. If you haven’t already done so, read Eric Ries’ The Lean Startup. In it, you will discover only three ways to create revenue:
    • You can pay for new customers. So, how do you plan to make the market aware of your products? How will you convert leads into customers? What will you do explicitly to retain customers?
    • Current customers can refer new customers? So, what will you do to encourage referrals?
    • Current customers can buy more. So, what will you do to encourage customers to increase their purchasing?
  • Pro Forma Financials. Income statement, cash flow statement, and balance sheet. Maintain all your assumptions that drive these financials in a list.
  • Cap Table. Only needed if you are interested in investors.

In what format should you document your plan?

This is a matter of taste. I strongly recommend against printing all your plans, polishing them, adding an introduction, table of contents, etc., and binding the document. The problem with this approach is that every one of the planning components is constantly evolving. If you polish and print it, it will be out of date by the following week. This is why I say I am against business plans, although I am for business planning.

Personally, I maintain a series of electronic company folders; each has a corresponding physical notebook containing selected key excerpts. Each folder contains all information I have collected on one aspect of the business. They combine “plan” and “actual” and are:

  • Market and Industry. This folder contains all my macro and micro market analyses and competitive analyses (old as well as latest in chronological order). It also contains copies of any related articles or reports others have written.
  • Marketing and Sales. This contains copies of marketing and sales plans (strategic and tactical). [Once the company starts, I add ad copy, brochures, web page designs, and so on.]
  • Equity. Initially, this contains just the projected cap table. [Once the company launches, it will also have copies of private placement memoranda, investor subscription agreements, accredited investor questionnaire forms, the stock option plan, all stock options granted, updated versions of the cap table, and so on.]
  • Board. Initially, this contains articles of incorporation and the bylaws. [Once the company launches, it will also include updated bylaws, board meeting minutes, and actions by written consent.]
  • Organization. Initially, this contains the organization chart and hiring plan. [Once the company launches, it will also contain employment contracts and updated organization charts and hiring plans.]
  • Financials. This contains pro formas by month and year for 5 years. At the front, I maintain a list of all assumptions, including all expenses (by year and by category), customer acquisition cost, sales cycle, average order size, periodicity (how often each customer will purchase), retention rate, viral coefficient, viral cycle length, and many of the items from the above folders. [Once the company launches, I add actuals.]

I also maintain a 10-minute slide presentation that captures the essence of some of the above.

How much detail? What is the right time horizon for business planning?

You should be as lean as possible without being irresponsible. Here are my thoughts on the specific parts of planning:

  • Analysis of Market. I believe that you must understand your market as thoroughly as possible or you are being foolhardy. The lean community might argue that truly revolutionary products create their own markets and it is impossible to understand the market until you test its behavior with your minimally viable product (MVP) in hand. The right answer lies somewhere between these two extremes.For example, let’s say your idea is to create fast food restaurants for diabetics. I would argue that it is important to fully understand both the demographics and the dietetic needs of diabetics before endeavoring down this path.On the other hand, you will not be able to determine exact recipes or menu items until test marketing (i.e., creating MVPs), and you won’t understand the risks associated with attracting diabetics to your restaurants when their family members are not diabetics without experimenting.
  • Analysis of Competition. Absolutely essential.
  • Threat of Entry. It is never too early to start planning for how you will protect yourself. If you delay, it may be too late.
  • Differentiators. Here, time horizon is important. You have to perform a delicate balancing act between what you believe are long-term differentiators for the majority of the market and what you believe are short-term differentiators for early adopters.The only sensible approach is to build a series of successively larger MVPs, learning as you go, adapting to what the market is telling you. All the time, however, you must acknowledge that you may not know if you are accommodating the needs of just early adopters or if they are indeed representative of the market majority.For planning purposes, do two things:

    (1) define what you believe are long-term differentiators. After all, without these, it is unclear why you should even be in business.

    (2) define a series of experiments to validate which features, delivery mechanisms, prices, promotions, marketing mechanisms, sales techniques, suppliers, and so on (collectively called differentiators), are most effective with the market.

  • Marketing and Sales Strategy. As stated above, you will have three components of your marketing and sales strategy: paid, referrals, and organic. As part of your plan, you should calibrate all three of these components with your goals. See Five Steps to Get and Keep Your Startup on Track. Once the company starts, you will revise these goals with actuals.
  • Financials. You are lean and are taking one step at a time. However, you still have a responsibility to verify that you are stepping in a direction that could yield great financial results. Create your pro forma income statement, cash flow statement, and balance sheet annually for at least 5 years, and monthly for at least the first two years.

Why do you need to plan your business?

The reality is that investors place their bets on startups less than 3% of the time[1]. The other 97% of their money goes to businesses that have already been through rounds of funding and have demonstrated that a market is willing to buy their product.

But when they bet on a startup, they demand a detailed plan for the business.

They won’t necessarily ask for a business plan per se, but they will perform due diligence. And when they do due diligence, they will be asking every possible question about your market, industry, product, marketing and sales, financials, governance, equity structure, intellectual property, and so on, so you need to have all this information somewhere.

If you are not planning on having investor money, why would you do anything less? After all, you are an investor in your own company, with time and money.

ABOUT THE AUTHOR:

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

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?

[1] http://www.forbes.com/sites/dileeprao/2013/07/22/why-99-95-of-entrepreneurs-should-stop-wasting-time-seeking-venture-capital/

When should you ask for investments?

1024px-Wonderland_Walker_2A successful startup company needs to create a sustainable growth model using paid, viral, and sticky strategies. However, before it gets there, a startup usually needs some cash investments to get things going.

Let’s say you have performed a financial analysis of your startup company and have determined that you will need $1M to keep it afloat until it can sustain itself.

When should you raise the $1M? No simple answer exists. In general, the longer you wait to raise any round of investments,

  1. The higher your valuation is likely to be because you have likely reached more milestones, like generating more revenue, obtaining more partners, producing more product, and so on. The higher the valuation, the less of the company you will have to “give away” to investors for a given amount of money.
  2. The higher risk you have of running of cash, so unscrupulous investors could take advantage of you by delaying their investment decision until you are desperate, thus forcing you to accept a lower valuation.

Some advisors will tell you to ask for all the money you need at one time because the investment-seeking process is so time-consuming that you want to do it as infrequently as possible. Get it over with at one time so you don’t have to do it again.

Some advisors will tell you to always raise more than you need because you have probably been overly optimistic in many of your predictions, and you want the cash cushion.

Some advisors will tell you to always raise less than you need (i.e., be as lean as you possibly can be) because your company’s valuation will always be higher later and you can raise less expensive money later.

Only you can make this decision. It is a delicate balance act.

What does cash flow look like?

Every startup’s cash flow looks like the following graph:

Cash Flow Figure

Notice that in the ideal world a successful company would burn cash at a slower rate of speed after each successive investment round; note that the slopes of subgraphs A, B, and C increase with each round. Eventually, the company sustains itself (at point C in this case) from operations without additional infusions of cash from external sources.

If the entrepreneur waits too long to raise investment round 2, line A will continue its downward trend below the horizontal zero line and the company will be out of business. If the entrepreneur doesn’t wait that long, but long enough so investors can see the company running out of cash soon, investors could just delay their decision.

In Summary

Entrepreneurs have to make their own decisions.

Some prefer to bootstrap using revenues to grow their businesses; this approach maintains ownership among founders and employees, but usually means slower growth because they can be cash-strapped.

Others prefer to raise as much as possible . . . and then spend it as fast as possible, reducing the risk that a competitor will beat them to the market.

Others take a middle of the road position of raising just enough capital, and spending is judiciously.

All a matter of style.

ABOUT THE AUTHOR:

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

WYNSUMM Cover

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?

Photo of Nik Wallenda (Wonderland Walker) courtesy of Kevint3141 (Creative Commons).

Should you sell investors common or preferred shares?

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

Why offer preferred shares to investors?

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

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

What are “downside insurance” preferences?

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

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

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

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

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

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

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

What are “upside insurance” preferences?

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

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

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

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

In Summary

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

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

ABOUT THE AUTHOR:

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

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

 

 

Why do I need a founders round?

No FoundationA founders round is an investment round that generates the initial cash needed to get the company started, but more importantly, it distributes equity to the founders of the company. In effect, it creates a foundation for the company’s ownership.

Do not start your company by simply giving stock to the founders. Doing this creates a taxable event for the founders because they have received something of value, a security, which is taxable. Rather, let the founders purchase a security, which establishes a basis for the purchase of the stock and which is not taxable.

What price do founders usually pay?

Since the company has just started, it isn’t worth very much. Usually, the founders pay a nominal amount, just enough so the company has enough runway to reach the first real investment round.

How many shares should founders purchase during the founders round?

No hard and fast rule exists. However, one million shares would give you good flexibility for the future. It would enable you to sell reasonable pools of shares to future investors and grant reasonable packages of options to employees, without having to do splits to create additional shares.

The only reason not to issue a million shares to the founders would be if your state of incorporation charges your company annual corporate tax based on the number of shares outstanding.

When should you conduct the founders round?

Ideally, you should conduct the founders’ round soon after you execute the paperwork that legally creates the company.

That way, the articles of incorporation and bylaws (if a corporation), the partnership agreement (if a partnership), or the operating agreement or articles of organization (if an LLC) can reflect the distribution of ownership.

Can you have a second “founders round” after the founding of the company?

Legally, founders’ shares are only available at company inception.

Founders can of course sell their shares to somebody. In this case, the new shareholder would pay the founders (not the company) for the shares.

And of course a company can always sell its treasury shares to a new shareholder. In this case, the new shareholder would pay the company. However, be careful! The investor must purchase them at a price using the current market value of the company, likely not the extremely low price the original founders paid for their shares,

When the original founder share price is paid for shares later in the company’s life, the new investor may be subject to a taxable event by the IRS.  Only in the case where nothing happened in the company between its founding and the time of the new investment would the potential exist for this to not be a taxable event.

So, the answer to the question Can you have a second “founders round” after the founding of the company? is  “Yes, sort of.” The new investor would purchase his/her shares in an “investment round”, which you can call whatever you want.

In summary

When you start a company – whether it is a corporation, a partnership, or an LLC – make sure that the founders/partners purchase their shares of the company. That establishes a basis for the security and will make tax filing a lot easier in the future. When shares are sold later on, make sure they are sold at the fair market price at that time.

 

Alan DavisAl Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books. He is not a CPA or an attorney, so the above is just his opinion!

 

Are Financial Goals Compatible With Investors’ Goals?

Square Peg in the Round HoleEntrepreneurs have their own ideas about what they want to accomplish financially. Articulate these goals and make sure that your business partners share your goals and your investors or lenders understand and support your goals.

 

Here are some general frameworks for financial goals:

External investors plus exit (Classic).

You’ll accept investments from a variety of sources, most likely angel investors and/or venture capitalists. You’ll ramp up revenues and profits and plan an exit strategy in which your external investors can achieve a great return based on an IPO or acquisition.

During execution, you need to focus on revenue growth and profit, and finding sustainable sales growth independent of cash infusions from lenders or investors. The value of the company upon the liquidity event will be based on a combination of trailing financial performance and future (leading financials) earnings potential.

External investors plus exit (Proof of Concept Only).

You’ll accept investments from a variety of sources, most likely angel investors and/or venture capitalists. You’ll perform research and development to prove a concept and plan to be acquired by a company that wants to commercialize that concept for which you have reduced the risk.

Upon acquisition, external investors can achieve a great return. Notice that you may not have necessarily achieved any revenue or profit prior to acquisition.

This approach works in only a few industries, e.g., pharmaceuticals, although it has occasionally worked in industries where “eyeballs” (i.e., having many visitors to your website, not necessarily generating revenues, let alone profit) could be seen by acquirers as potential sources for future revenue.

Two great examples are Corus Pharma and Instagram. Corus Pharma was acquired by Gilead Sciences in 2006 for $365 million, based on terrific proofs of concept for two new drugs, although it had effectively zero revenue.

Instagram was acquired by Facebook in 2012 for $1 billion, based on its “eyeballs,” although it had effectively zero revenue.

This is usually a highly risky “plan” for a business. Although such companies make headlines, so do lottery winners.

External investors with income.

You’ll accept investments from non-traditional investors. You’ll ramp up revenues and profits and distribute profits annually to the investors who can achieve great returns in the form of income.

This tends to be appealing to “non-traditional” investors because neither angels nor venture capitalists are commonly interested in income-producing deals. Friends and families might be. During execution you need to focus on profits.

Lifestyle company.

Your plan is to grow and achieve enough cash from the company so you can support your family. You may or may not accept loans, but if you do, you plan to pay them back with interest. There is no “exit.” During execution, you need to focus on cash generation.

External investors with MBO (Management Buyout).

I see quite a few inexperienced entrepreneurs put together business plans that call for this option.

They really don’t want investors as business partners. Investors are simply a short-term source of capital, a necessary evil; not business partners.

Typically, their business plans are highly optimistic and generate huge amounts of cash, so their plan is to buy out the investors and get rid of them.

This framework has a few problems:

(a) First of all, this is not a management buyout; this is a stock repurchase. The “proposal” calls for the company’s cash to purchase the investors’ stock, not thefounders’ cash.

(b) Second, if the company is doing extremely well, the investors likely want to be part of the action, and they have a vote! Of course, if they want to exit, and you don’t want to exit, there is a mismatch in objectives and the right thing to do is to help the investors exit, but that’s not something you’d plan to do from inception!

(c) Third, rarely do new entrepreneurs appreciate how much uncontrolled risk external investors are taking, and thus how much return they expect (and deserve). If the company is doing extremely well, they want big returns.

(d) Fourth, in all likelihood, the company will not be creating as much cash as the plan calls for. In fact, a responsible company reinvests its cash into ongoing operations to insure future growth; it doesn’t hoard its cash.

Summary

Obviously, it is also possible to combine various elements of the above. Your company can achieve financial success if it is on the path toward accomplishing any of the above five scenarios. Make sure that you understand what you are trying to achieve and make sure that all your business partners understand and have compatible goals as well.

 

Alan DavisAl Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Four Things a Balance Sheet Tells You

BS PhotoWhen you plan to start a company, you need to create pro forma financial statements. Pro forma financial statements include an income statement, a cash flow statement and a balance sheet.

Based on a set of assumptions, a pro forma balance sheet shows all the things your company would own (its assets), all the things it would owe (its liabilities), and their difference (shareholders’ equity).

These are the four questions the balance sheet answers for you and your potential investors:

  1. Will you be able to pay your bills?
    – A current ratio less than 1.0 is a fairly good indication that the company is going to have problems. As your company evolves, your current ratio should become (and remain) above 1.2.
    – Net working capital defines the cash you have available for paying off debt and running your company on a day-to-day basis.
    – A negative value means you have a shortfall, and unless something drastic is done (like securing short-term loans), you will not be able to continue as you are.
  2. Where are you getting capital from? The debt to equity ratio (D/E) tells you what proportion of your capital is coming from loans vs. investments.– A value of 1.0 means that you are getting half from loans and half from investors.
    – A value greater than 1.0 means that more of your money is from loans and less is from investors. The disadvantages of this are that you must continually make payments on loans (this drains cash and decreases profits), and loans are extremely difficult for start-up businesses to secure without collateral. The advantage however is that you will likely be able to maintain more ownership.
    – A value less than 1.0 means that more of your money is from investors and less is from loans. This is more typical for a start-up.
    – 
    There is no single right value for a D/E ratio for a start-up. The two primary drivers of what will be the right value for you are: (a) the standards for your industry, and (b) your comfort level with debt.
  3. How efficiently are you using investors’ money to produce profit? Return on equity (ROE) tells you the answer.
    – Most start-ups will have a negative ROE for the first 1-2 years, and will eventually have a positive ROE.
    – For publicly traded companies, a ROE of 15% to 20% is considered good, but this measure is not so important for a start-up. On one hand, most investors are more interested in the internal rate of return (IRR) on their investment upon an acquisition than the annual ROE. On the other hand, an acquirer is likely to pay a premium price for a company with a high ROE because it indicates a more solid company.
  4. How quickly are you moving your inventory?
    – If higher than industry averages, you run the risk of running out of stock. If lower than industry, you run the risk of spoilage and/or obsolescence.
    – If much higher or lower than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? One does not achieve such changes without specific actions.

Let’s take a look at a balance sheet to understand how these four questions get answered.

The figure below shows a balance sheet for the first five years of a company.

Sample BS

All balance sheets are organized into two basic parts – (1) Assets and (2) Liabilities & Shareholders’ Equity:

Assets

Assets are a list of all items that the company “owns.” Two kinds of assets exist: current and other. Current assets are those that can be easily converted into cash in a reasonably short period of time, specifically one year.

Assets include:

  • Cash (or cash equivalents) – a statement of any assets that can be converted into cash almost instantly.
  • Accounts receivable – amounts owed by your customers for products they have purchased.  You have booked the revenue, but have not yet received their cash payments.They are considered current because it is assumed that customers will be paying you soon.
  • Inventory – considered current because it is assumed that you can sell it to customers (or if you are a manufacturer, you can transform the raw materials or work in process into finished products, which you can then sell to customers) within a year.
  • Total current assets – the sum of the previous three items.
  • Fixed assets – the major purchases that you have made, less their depreciation. It is shown on a line labeled property, equipment, and improvements, net.
  • Total assets – the sum of the fixed assets and current assets.

Liabilities and Shareholders’ Equity

This section contains current liabilities (i.e., money the company owes that is due within 12 months), other liabilities (i.e., money the company owes that is due later than 12 months) and shareholders’ equity:

Liabilities include:

  • Accounts payable – items purchased from suppliers or vendors, booked as expenses, but not yet paid for. It is considered current because it is assumed that you will pay it soon.
  • Accrued liabilities – expenses (such as salaries for your employees) that you incur on a regular basis but do not pay until the following period. Since most start-ups pay their employees monthly, accrued liabilities at the end of any month (and in fact at the end of any year) will equal one month’s payroll.
  • Short-term debt – the balance of all your loans (both those that are due within 1 year and those payments that are due within a year for longer term loans).
  • Total current liabilities – sums the previous three items.
  • Long-term debt – the balances of all loans due after one year.
  • Shareholders’ equity   – composed of two parts: (a) paid-in capital, i.e., the actual amount that investors paid for their stock, and (b) retained earnings or accumulated deficit, whichever applies, copied directly from the cum net entry of the income statement.

If all calculations are done correctly, the sum of all assets should equal the sum of all liabilities plus shareholders’ equity.

Financial Ratios

Below the balance sheet, some companies report values of some standard financial ratios. These often include:

  • Current ratio. Your current assets divided by your current liabilities; both of these values appear right here on the balance sheet.
  • Net working capital. Your current assets minus your current liabilities (it’s not really a “ratio”!); both of these values appear right here on the balance sheet.
  • Liabilities/equity (aka D/E aka debt-to-equity ratio). Your total liabilities divided by shareholders’ equity; both of these values appear right here on the balance sheet.
  • Return on equity (ROE). Your net income after tax (from the income statement) divided by shareholders’ equity (from the balance sheet).
  • Inventory turnover. Your cost of goods sold (from the annual income statement) divided by the average inventory (from the balance sheet). Average inventory is generally calculated as the average of inventories at the beginning and end of the fiscal year. Inventory turnover is a measure of the number of times during a year that the entire inventory is sold (or otherwise used). It is highly dependent on the industry. Thus, for example, a fresh seafood retail business would expect an inventory turnover of around 365, while an art dealer would expect an inventory turnover of around 2.

The balance sheet differs from the pro forma income statement and the pro forma cash flow statement.  The pro forma income statement, which tells you if you will be making revenues and profit, and the cash flow statement, which tells you where your cash will be coming from and going to, are dynamic reports.  They show you what will be happening over periods of time.

Unlike those reports, the balance sheet shows you the state of your company at a point in time. It shows you what your company would look like if the calendar and clock could be stopped for just one moment; it is like a snapshot, showing you everything the company owns and owes at that moment.

In the case of a person, the difference between what you own and owe is your net worth. In the case of a company, that difference is the shareholders’ equity.

Using your balance sheet is the best way to view everything the company owns and owes at that moment.

 

Other articles you may find helpful in the series:

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Photo courtesy of Simon Cunningham (Creative Commons).

Four Things a Cash Flow Statement Tells You

CFS PhotoWhen you plan to start a company, you need to create pro forma financial statements. Pro forma financial statements include an income statement, a 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.

The cash flow statement answers four questions for you and your potential investors:

  1. Does the cash at the end of the period (the last line of each column of the cash flow statement) equal 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.
  2. Does the company run out of money? Is the cash balance at the end of any period negative? Check on both the annual cash flow statement and on the monthly cash flow statement.
  3. Does the company’s core business eventually generate enough cash to sustain itself? You will learn this by examining the line net cash provided (used) by operating activities. For the first few years, this is likely to be negative (with the cash shortfall made up for by influxes of cash from loans and/or investments).But eventually, the company should be able to sustain itself. When net cash provided (used) by operating activities becomes positive, the company has achieved a sustainable growth engine (see Eric Ries’ The Lean Startup).
  4. Is an investment being used to pay off a loan? Most investors want their cash to be used to grow the company; they do not want it used to retire debt. Such a situation can be most easily seen by examining the monthly cash flow statement. Look at any month in which the line issuance of stock has a positive entry. Is there a corresponding negative entry on the line proceeds from (payments on) notes payable? If so, there could be a problem.However, in some cases this could be okay, e.g., when the lender holds a convertible note and the note is simply converting into equity. In such cases, no cash is actually changing hands; it is simply a bookkeeping entry and a conversion from debt to equity for the same party.

Let’s take a look at a cash flow statement to understand how these four questions get answered.

The figure below shows a cash flow statement for the first five years of a company.

Sample CFS

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:

 Cash flows from operating activities

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

  • Depreciation was on the income statement and contributed to expenses (and thus decreased profit), but unlike other expenses, it caused no corresponding reduction to cash. Therefore the first thing we do on the cash flow statement is add back the amount of depreciation.
  • 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 period for something that they purchased in a previous period, 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) cash 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.
  • 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 net cash provided (used) by operating activities.

Cash flows from investing activities

Cash flows from investing activities show cash that relates to your major purchases (or sales) of fixed assets (e.g., real estate, equipment, acquisitions, vehicles, computers, and so on.)

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 purchase 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 flows from financing activities

Cash flows from financing activities show cash that relates to financing your business, e.g., loans you accept (or make payments on) and investments received by the company.

It 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 net cash provided (used) by financing activities.

Summary lines on your cash flow statement

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

  • 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.

Many new entrepreneurs confuse cash with profit. Your company could be profitable (as reported on your pro forma income statement) and you could still run out of cash. You could also be unprofitable and have cash (e.g., with the help of highly optimistic investors).

Using your cash flow statement is the best way to find out exactly where your company is getting and spending its cash.

Other articles you may find helpful in the series:

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Photo courtesy of Ken Teegardin (Creative Commons).

Seven Things an Income Statement Tells You

Photo for income statementWhen you plan to start a company, you need pro forma financial statementsPro forma financial statements include an income statement, cash flow statement and balance sheet.

Your pro forma income statement (also called profit and loss statement, or P&L statement) is the tool used by businesspeople and investors to determine if a company is profitable (or not) over a period of time.

It shows what the revenues, cost of goods sold, expenses, and profits of a company would be, based on a set of given assumptions.

The income statement answers seven questions for you and your potential investors:

  1. Are revenues growing fast enough to make it an attractive investment?
  2. Are revenues growing so fast that your credibility will be questioned?
  3. Is your gross profit margin (i.e., gross profit divided by revenues) within acceptable limits for the industry? If higher than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? It won’t happen by accident!
  4. Are expenses within acceptable limits for your industry? Or are you predicting significant revenue growth without the corresponding expenditures incurred by others in your industry?
  5. Are EBITDA/Revenues and Net income/Revenues within acceptable limits for your industry? If higher than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? One does not achieve such higher performance levels by just being “good.”
  6. Is the first year profitable? For most start-ups, EBITDA for the first year will be negative . . . and that’s okay!
  7. Is the company predicted to “dig itself out of the hole.” Although the first year will almost always exhibit negative profit (aka a loss), cum net tells you how long it will take for the cumulative profits to compensate for the early losses.

Let’s take a look at an income statement to understand how these seven questions get answered.

The figure below shows an income statement for the first five years of a company.

Sample IS

All income statements are organized into 4 horizontal sections:

Revenues

The first section shows all primary revenue sources.

Cost of goods sold (aka COGS)

The second section shows costs associated with actually creating products that were responsible for revenues. This includes the cost of raw materials, shipping products to customers, and labor associated with manufacturing and maintaining inventory.

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

The third section lists all expenses incurred by the company categorized by corporate division: General and Administration, Manufacturing and Production, Marketing and Sales, and Research and Development.

Summary lines on income statement

The fourth section is a series of totals and summaries that help you understand the company. They include:

  • EBITDA. Literally, earnings before interest, (income) tax, depreciation, and amortization. This is 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.
  • 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 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.
  • Net income (loss) after tax. Calculated by subtracting interest and income tax from EBIT.
  • Cum net. Cumulative net earnings. The sum of all net incomes for all periods up to and including the current period.

Except in very unusual circumstances, revenue is terrific, but revenue without gross profit is not sufficient. Similarly, gross profit is terrific, but gross profit without positive EBITDA is not sufficient.

Read Four Things a Cash Flow Statement Tells You to learn more about the pro forma cash flow statement.  At that point, we’ll also see that positive EBITDA is great, but positive EBITDA without positive cash flow is also not sufficient.

Using your income statement is the best way to find out exactly how much revenue and profit (or loss) your company is generating; and how efficient it is in generating that profit from the sales.  These are imperatives for launching and running a viable business.

Other articles you may find helpful in the series:

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Photo courtesy of Jessica Wilson (Creative Commons).

Why My Startup Need Pro Forma Financial Statements

by Al Davis and Nicola Roark

Money launchWhen you plan to start a company, you need pro forma financial statements.  Pro forma financial statements include an income statement, cash flow statement and balance sheet.

Do these really matter or could you take your great idea, score some investment money and get your product to market more quickly without pro formas?

This question puzzles a lot of startups so let’s answer it.  While there’s no wrong answer, each path has its own likelihood of success:

No pro forma financial statements = low probability of success

The reason this path has low probability of success is not because you don’t have a great idea!  Your idea is probably fantastic but it’s even better when you can back it up with financial assumptions that make sense.

The reality is that investors place their bets on startups less than 3% of the time[1].

And when they bet on a startup, they demand pro forma financial statements and at least some kind of detailed plan for the business.

The other 97% of their money goes to businesses that have already been through rounds of funding and have demonstrated that there is a market willing to buy their product.

Pro forma financial statements = high probability of success

Investors take their risks with those that have a reasonable chance at being successful and returning their investment, plus some, to them.  Investors want to know when to expect a return on their money.  Pro forma financial statements tell them that.

Let’s take a quick look at the pro forma financial statements that all investors expect from a startup. Understanding the value of each adds tremendous power to running your business, growing your business, and to the proposition you make to investors.

Your pro forma income statement (also called profit and loss statement, or P&L statement) is the tool used by businesspeople and investors to determine if a company is profitable (or not) over a period of time.

It shows what the revenues, cost of goods sold, expenses, and profits of a company would be, based on a set of given assumptions. Your income statement answers seven questions for you and your potential investors.  To learn more about these questions and their answers, read Seven Things an Income Statement Tells You.

Using your income statement is the best way to find out how efficient your company is in generating that profit from the sales.  These are imperatives for launching and running a viable business.

Your 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.

Many new entrepreneurs confuse cash with profit. Your company could be profitable (as reported on your pro forma income statement) and you could still run out of cash.

The cash flow statement answers four questions for you and your potential investors.  To learn more about these questions and their answers, read Four Things a Cash Flow Statement Tells You.

Your pro forma balance sheet shows all the things your company would own (its assets), all the things it would owe (its liabilities), and their difference (shareholders’ equity), based on your assumptions.

The balance sheet answers four questions for you and your potential investors.  To learn more about these questions and their answers, read Four Things a Balance Sheet Tells You.

Understanding the value of your pro forma financial statements is not only a benefit to you and your business, it’s an expectation from investors.  They are the compass on your business journey and without them you’ll quickly start drifting.

Using your pro forma financial statements to chart your course, demonstrate your business acumen, and recommend course changes is the most reliable compass you, and your investors, can have.

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Nicola Roark is a Marketing Consultant and Strategist working with entrepreneurs and startups. Her business allows her to do two things she loves; collaborate with businesses who have a dream and develop the strategy and content to take it to market. Visit her website: www.exhilarationmarketing.com or email her: nicola.roark@exhilarationmarketing.com for more details.