Category Archives: Pro Forma Projections

6 Reasons You Should Never Start a Company

Do Not EnterIf you are looking for reasons why you should not start a company, read on!

1. You Could Lose All Your Savings

As a founder, you are investing in your startup. You’re investing your time and your energy; you’re investing yourself. In addition to that, it’s also wise to invest financially in every round if you can. That way when you are raising money and potential investors ask “do you have skin in the game?” you can honestly answer “yes,” and when they ask or “if I say yes, will I be the first investor?” you can honestly answer “no.”

Putting you own money into the company demonstrates commitment. If this requires you to take out a second mortgage or a personal loan, so be it.

If you can’t commit to losing your savings, how can you expect others to put their assets at risk?

2. You Could Lose Other People’s Money

I thought that losing my own money was painful, but that was before I lost other people’s money. Now that’s painful! After all, when investors give you their cash in return for equity in a company you have founded and are leading, they are making a loud and clear statement that they believe in your idea and they believe in you.

Even when you involve your stakeholders and keep shareholders informed of all decisions being made, even when the vast majority of investors bear no hard feelings whatsoever, you spend considerable time looking back at past decisions wondering “what if I had done things differently?”

Bottom line: When you accept other people’s investment dollars, be prepared for the possibility that pain might follow if you fail. That pain might be self-induced, or might come from the investors.

3. You Could Hire the Wrong People

You can’t do it all yourself. You need to hire others to help make the dream come true. If you make the wrong hires, quality will be compromised, too much money will be spent, customer service will go down the tubes, the morale of the “good hires” will suffer, and so on.

4. You Could Lose Control

You like control. After all, the company you are envisioning is “your baby.” You want to control it. When you need to raise cash, you will be telling potential investors how much cash you need and what you plan to do with it. The percent of the company they get for that investment will be up for discussion.

Let’s say you need $500,000. You want to maintain control so you have no intent to sell more than 49% of the company. But the investors value your company at just $800,000. That means if you want their $500,000, you’ll need to sell them 5/8 of the company.

5. You Could Build the Wrong Product

You raise $500,000 from investors and build the “perfect product” for the market. You execute an expensive product launch with a major media presence. And nobody buys the product. The product is a total flop. You either misunderstood the needs of the market, you were too early or too late in the market window, or the competition outsmarted you with an even more impressive product.

6. Your Customer Acquisition Cost Could Be Much Higher than Expected

You did extensive financial planning, and that included modeling the sales process. Only one problem: you think it will cost you $250 to acquire each new customer. What happens if it actually costs you $750 to acquire each one? Now everything in your financial plan falls apart.

In summary

If the above situations scare you, you have an easy way to avoid them: Don’t start a company. Starting a company is not for the pessimist or for the risk-adverse. Nor is starting a company for those who want to get rich quickly and live on a beach.

Starting a company takes courage and optimism.  It requires stubbornness and the ability to rewind and clinically assess mistakes. It tolerates failure but demands success. As crazy as it may sound, if that excites you, you might be about to take your great idea and start your own company!

Let me close by sharing with you three of my favorite quotes:

 “Far better to dare mighty things, to win glorious triumphs, even though checkered by failure, than to rank with those poor spirits who neither enjoy much nor suffer much.  [They] know not victory, nor defeat.”

Theodore Roosevelt

“It is good to have an end to journey toward; but it is the journey that matters, in the end.”

Ursula K. Le Guin

“First, say to yourself what you would be; then do what you have to do.”

Epictetus

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?

Four Ways to Validate Your Great Startup Idea

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

Thumb

Validate your idea by answering four simple questions:

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

Let’s explore these one at a time.

1. Is the market right?

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

Size of market

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

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

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

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

Targeting Customers

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

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

Converting Customers

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

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

2. Is the industry right?

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

Competition

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

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

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

Partners

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

Differentiators

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

3. Will it make money?

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

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

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


 

Offtoa Screen1


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

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

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

4. Will it need money?

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

In summary

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

☐ Is your total available market large enough?

☐ Is your initial target vertical market focused enough?

☐ Is it easy to find leads?

☐ Is it easy to convert leads into customers?

☐ Do you know your competition?

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

☐ Are your differentiators unique and compelling?

☐ Will your startup make money?

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

☐ How much money do you need?

ABOUT THE AUTHOR:

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

ABOUT OFFTOA

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

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

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

 

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/

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.

How Investors Value Your Startup

Let’s start by discarding two myths:ダイヤモンド査定

  • Investors do not want control of your company! That is the last thing they want. What they do want are (a) handsome returns, and (b) for you to responsibly manage your own company so they don’t have headaches.
  • Investors do not care what past valuations were. On previous rounds, you may have received poor advice and valued your company at, say, $5M, and you found some unfortunate investors to purchase stock at that ridiculous valuation. Oh well, that’s too bad. It has zero effect on what the company is worth today.

What do investors want?

So, what do investors want? And how will they decide what your company is worth? Five main factors influence them:

  1. Is the opportunity exciting? If it isn’t exciting, they won’t bother valuing the company at all.
  2. Is the team qualified to execute on the plan? If not, you just aren’t worth the risk.
  3. Valuation based on current performance. Based on current trailing financials (i.e., what you have already done regarding revenues and profits), and multiples applicable to your specific industry, what is your company worth today?
  4. Valuation at desired time of liquidity. Based on expected performance (i.e., what you say about expected revenues and profits in your plan), and multiples applicable to your specific industry, what will your company be worth in the future? See below and blog on Determining Future Valuation.
  5. At what stage is the company? The biggest hurdles a startup has are:
    • building a product
    • getting the first revenue
    • demonstrating a repeatable sales model
    • demonstrating sustainable growth without continuing to invest external cash.

As you jump each of these hurdles successfully, the risk of total failure decreases significantly. Investors have their own rules of thumb about how that “risk of total failure” affects valuation. Here are my rules of thumb:

  • If you have not yet built your product, assume valuations will be no more than 25% of the valuations calculated using the techniques shown below.
  • If you have built your product but have not yet received revenue, assume valuations will be no more than 50% of the valuations calculated using the techniques shown below.
  • If you have built your product, started receiving revenue, but have not yet demonstrated a repeatable sales model, assume valuations will be no more than 75% of the valuations calculated using the techniques shown below.
  • If you have demonstrated a repeatable sales model and are looking for investments to “ramp up,” then the following techniques for valuation are applicable.

What To Do With Future Valuation?

Let’s talk a bit more about item 4 above. What will investors do with that future valuation once it is computed? They certainly won’t use it for today’s valuation. What they will do is use it to determine what value the company needs to have today so they can receive an acceptable return on their investment. Assuming that FV is the computed future valuation of the company at the time of liquidity, IRR is the investor’s desired rate of return and n is the number of years between now and the liquidity event, the calculation goes as follows:

Current Value of Company = FV / (1 + IRR)n

So, for example, let’s say the FV is determined to be $15M (using the techniques of the blog, Determining Future Valuation), and the investors desire a 50% IRR (not unreasonable considering the degree of risk) over 5 years. Plugging those numbers into the above formula, we get:

Current Value of Company = 15M / (1 + .5)5 = $1.98M

So, if you are looking for those investors to invest $500K now, expect them to ask for 25% of the company (because $500K is 25% of $1.98M); if you are looking for those investors to invest $250K now, expect them to ask for 12.5% of the company. And so on. But this applies only after you have demonstrated a repeatable sales model.

Now you need to factor in the risks described above. If your company is:

  • Pre-product, valuations decrease by around 75%. So continuing with the above example, the company now has a current valuation of around $500K. So, if you are looking for those investors to invest $500K now, expect them to ask for 100% of the company (obviously not a good idea); if you are looking for those investors to invest $250K now, expect them to ask for 50% of the company.
  • Pre-revenue, valuations decrease by around 50%. Continuing with the above example, the company now has a current valuation of around $1M. So, if you are looking for those investors to invest $500K now, expect them to ask for 50% of the company; if you are looking for those investors to invest $250K now, expect them to ask for 25% of the company. And so on.
  • Pre-repeatable sales, valuations decrease by around 25%. Continuing with the above example, the company now has a current valuation of around $1.5M. So, if you are looking for those investors to invest $500K now, expect them to ask for 33% of the company; if you are looking for those investors to invest $250K now, expect them to ask for 16.6% of the company. And so on.

None of the above is motivated by greed or a desire for control; it is pure economics. Investors want (and deserve) a fair return for their investment.

Of course many other factors come into play including experience, negotiation skills, degree of desperation to obtain cash, and availability of competition for deals (for the investor) and investors (for the entrepreneur).

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

3 Steps for Micro-Pivoting in Startups

Steering wheel of old sailing vesselThanks to Eric Ries, we now understand the term pivoting a company. That is, when we determine that a major assumption we previously made about our company, whether it be about the product, the market, or the competitors, is wrong, we redirect the company making different assumptions.

However, when leading a company, as when steering a ship, there is also a need to implement hundreds of small micro-corrections (micro-pivots) to the path.

Step 1: Determine “Planning” Values for Your Key Measurements

The ability to grow a company is determined by seven key variables (see 5 Steps to Get Your Startup on Track and Stay on Track to learn about them):

  1. Customer Acquisition Cost (CAC)
  2. Sales Cycle (SC)
  3. Average Order Size (AOS)
  4. Periodicity (P)
  5. Retention Rate (RR)
  6. Viral Coefficient (VC)
  7. Viral Cycle Length (VCL)

Let’s assume that you have decided that financial success will be determined by the internal rates of return (IRR) to external investors. The best indicators of whether they will receive those IRRs are if the company achieves its revenue, EBITDA, and EAT (earnings after tax) goals of $22M, $11M, and $8M.

Plan

During the planning stage, you will determine the values for the seven key drivers of company growth that are both feasible and drive the company to financial success as defined in the previous paragraph.  Use software to verify the relationship between values for these variables and financial results.

Step 2: Analyze Your Results Frequently

Each month, calculate the actual values for the seven key drivers of company growth.

  1. Customer Acquisition Cost (CAC). Determine how many new customers were acquired in the past month as the result of your direct marketing and sales efforts (eliminate, for example, referrals; but include new acquisitions through search engines). Divide the money you spent on marketing and sales this month by the number of newly acquired customers.If you have not yet determined a value for SC, but assume it is between 1 and 3 months, you could instead use the rolling average expenditures for marketing and sales over the past 3 months and divide that by the number of newly acquired customers for the most recent month. 
  2. Sales Cycle (SC). For some businesses, SC will be easy to determine; for others not so easy. For example, if you are using a direct sales force, you will be able to calculate fairly easily how long it takes from lead generation to closing a sale.On the other hand, if your sales are more passive, such as online sales, you will only be able to determine SC by plotting changes in budgets and actual sales over a period of many months. 
  3. Average Order Size (AOS). The actual for this is easy to calculate for all businesses. If your customers purchase more often than once per month, just aggregate their purchases and record their average purchases per month.
  4. Periodicity (P). The actual for this is also easy to calculate for all businesses. Just keep track of how often customers return to purchase again.
  5. Retention Rate (RR). When you first start your business, this will be very difficult to compute because a few lost customers could have drastic effects. By the time 1-2 years have passed, you should be able to have a pretty good idea of how loyal your customers will be.
  6. Viral Coefficient (VC). Only two ways exist to compute this:
    • Create a rewards-based referral program so you can keep track of exactly how many new customers are being referred by existing customers.
    • Ask all new customers how they heard about you (this is much less accurate).

Until you do one of these, you will have to assume that VC is zero or you can be optimistic, and keep entering it as a guess every month.

7.  Viral Cycle Length (VCL). Same comments apply here as for VC.

Enter these actual values and see whether they lead to financial results as good as the original results. If you are like most startups, you will find early results disappointing, and will have to decide how long you will wait before executing changes.

Actual

Use software designed for fast and easy financial reporting to identify that the new (actual) values for these variables have created quite different financial results and thus determine whether or not to pivot.

Step 3: Execute a Pivot or a Micro-Pivot

A pivot is executed when:

  • The actuals portend a poor financial outcome
  • You believe that the actuals reflect the best the company can do

In such a case, you may need to change the product, change the target market, change the way you sell the product, find new channel partners, and so on. These are significant pivots.

A micro-pivot is executed when:

  • The actuals portend a poorer financial outcome than you planned
  • You believe that the actuals can be improved by changing tactics, not through major company redirection

In such a case, examine each key driver of company growth and determine what actions you can perform to improve its specific value. Here are some examples:

  1. To decrease CAC:  Change the content or vehicles for advertisements. Change your messaging. Offer better pricing or better promotions.
  2. To decrease SC:  Offer better incentives to the salesforce.
  3. To increase AOS:  Offer quantity discounts.
  4. To increase P:  Offer frequent buyer programs.
  5. To increase RR:  Improve your product’s stickiness. This is the most difficult to improve in the short term.
  6. To increase VC and decrease VCL:  Offer referral programs.
  7. It might be that all the values are sound; you just need to spend more money on marketing and sales during the early stages of the company to “prime the growth engine.”

When you implement a series of micro-pivots, use graphs.as shown below.

 Graph 1
 Graph 2
 Graph 3

These will show how your incremental improvements to actual values for the seven key drivers of company growth are driving the company increasingly toward the predicted fifth-year revenues, EBITDA, and earnings after tax, as a function of time.

These seemingly small but very important adjustments have the power to right the ship and set your business back on the course for success.

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

5 Steps to Get & Keep Your Startup on Track

If you plan your startup’s growth appropriately, you can use the identical process to keep your startup on track after you launch.

The ‘Get on Track’ Process:

1. During planning, select values for 7 key drivers of your company’s growth.

Tracka. 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?

b. Sales Cycle (SC): How many months transpire between your expenditure of marketing dollars and the acquisition of new customers?

c.  Average Order Size (AOS): How much revenue do you expect to generate each time a customer makes a purchase?

d. Periodicity (P): How often will each customer make a purchase?

e. Retention Rate (RR): What percent of existing customers will remain customers at the end of each year?

f.  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.

g. Viral Cycle Length (VCL): How many days will transpire between customers becoming new customers and their referrals becoming new customers?

Note that when planning your company, some of the above (e.g. VC and VCL) will have to be just guesstimates . . . and that’s okay.

However, you should be able to make somewhat more intelligent guesses on CAC and SC based on the type of business and the kind of marketing and sales you expect to conduct. And P and RR values should be much easier to estimate from the beginning based on your business.

2. Before you launch your company, verify that the estimates you’ve selected for the 7 key growth drivers will 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, adjust the values until the company becomes successful.

3. Launch your company.

The ‘Stay on Track’ Process:

  1. 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.
  2. 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 must change your strategy.

Change Your Strategy

Based on which key growth driver you want to affect, different strategic changes are in order. Many options exist in every case, but here are just a few ideas:

  • 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 the 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 the referrer and the new customer. Make products so exciting that they create a buzz. Add features that increase your product’s value to customers.

As you can see, these seven key growth drivers are not only fundamental to planning your startup, they are also fundamental to keeping your startup on track. Not all are easy to estimate, but you can at least determine in the planning stage what values you must achieve to be a viable company.

Once you launch your company, not all seven are easy to measure, but as you progress, they will become easier. Drive your engine towards success!

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

“On Track” Photo courtesy of Clare Wilkinson (Creative Commons)