Take-aways from a talk in the Trust Center on 8/4/16
Why do we need to build financials?
- The CEO’s #1 role - Don’t run out of cash! Building a good financial projection will help you know your oxygen supply
- Raising money – demonstrating that you are financially capable of managing your business
- Validating/changing your assumptions
- Comparing forecast to actuals will help you better understand what you need to do next to make a viable business?
- This will help to understand the drivers for your business success and set appropriate goals (are fixed costs always high? How much sales revenue do we need to generate each quarter/ year to be profitable?)
Income statement walkthrough
- Revenue: money coming in from customers (sales after any discounts)
- COGS: direct/indirect: The materials, labour, facilities, costs of customer support/ field support…
- This is NOT your engineering (R&D) or HR expenses but rather expenses that are directly related to your sold products
- Gross profit margin = (Revenue – COGS)/ Revenue: this is what makes the real difference. The ratio is what matters to show you run your business efficiently.
- Sales & marketing
- SG&A – rent, accounting, HR, IT
- EBIDTA – operating payoff. The earnings you have left before taxes, depreciation, appreciation.
Investors care for
- Revenue line – This shows the order magnitude of this investment and the growth rate?
- Gross margin – This shows efficiency. Also shows where the company spends most of its money and what’s the operating profit
- Tip; Keep your statement clean and simple to make it readable for your investors.
- Operating profit matters! Your annual trajectory shows how much you need to spend in order to scale. And this shows how much funding you need to raise.
- Ask yourself: Do I like the picture that I am painting? In the first year, you have many “crazy” assumptions. Later as the business evolves you will revise this and see whether you can improve things and what underlying assumptions you want to change.
- Start with the top line: Is the business growing to what I think the opportunity is? what is our improvement level and what are we doing that prevents us from getting an even better result?
- Look at your expenses at Y1-2 and extrapolate it to further years. Similarly, compare % of change/ improvement from Y1-2 and build on this for Y3-5.
- A strong projection lies on credible assumptions so be thoughtful and realistic when making them.
Building sales projection
- This is the biggest challenge - The market doesn’t come to you, you need to go get it!
- Think about the entire customer funnel - how you get traction? And, when you do, how many people are actually going to try the product? Convert to a paid version?...
- Try to avoid the best-case - worst-case scenarios. Go in with one number that you can justify, that you can walk all your numbers through and that is credible.
- Don’t try to squeeze everything to this 4 Y projections. You might not capture all the market or grow at the same pace every year
- profit margins too big- as you grow your company you will most likely be less efficient so this will make your profit margin lower
Staffing drives departmental expenses
- Be prepared to spend 2/3 of your expenses on salaries.
- The sales staff is a different story – the payment varies a lot depending on your industry. Overall sales reps average salary will be much higher than the average employees.
Financial projections – technology companies
- Questions you should ask yourself:
- How many employees I have/ need and how much $ revenue I have per employee? A good amount will vary between $150K-$350K
- How much should you pay yourself? Enough not to starve but to stay hungry J
Revenue growth exercise takeaways
- Units’ sales matter – think about your product lines: How many units are you going to sell from each product? Will there be a new product line? How is this going to affect the current product line sales? Is there a risk for product cannibalization?
- Set goals – try to reach a specific number then from there think: How do I get there? Design your unit sales accordingly.
- When planning, think of your unique operations – what is the average sales size? How many products per sale? Is it credible that a salesperson can close X deals/year?
- If you as a founder can sell X deals/year it is a credible assumption that a sales expert will be able to sell at least the same.
- Don’t let your formulas determine your projections – Instead, think about reality: what really makes sense?
- Materials costs – almost the same spreadsheet for revenue but with costs instead
- Staffing costs (tech supervisor, manufacturing hires, purchasing staff, etc.).
- Use assumptions – for every $X revenue I will need A manufacturing hires, B purchasing staff etc.
- Floor space/ facilities
Departmental expenses: R&D
- R&D expenses are interrelated to many other expenses: If you need to expand your R&D, you’ll need to hire more engineers to make this work, more facilities, and more materials for prototyping...
- Recommendation: do a quarterly P&L. This will help you figure out issues, needs and improvement opportunities much earlier, especially staffing, and adjust quicker
- Salary expenses: for simplicity, keep +15% of salary payments to pay for employees medical insurance
- This will be 60-70% of your expenses so make sure you hire people that will help you grow your business.
- Non-salary expenses: here is a good place to use formulas. Especially for expenses such as travel.
- Monitor your expenses carefully – unlike revenue, which is harder to accurately predict, the expenses line is something that you can track so adjust it frequently to avoid mistakes.
- Tip: build an equity distribution spreadsheet. Walk your team members through this to see how in the future everyone is satisfied with the $ distribution based on the projection of the business growth.
- Highly recommended that all shareholders have a vesting period!
- When equity is distributed, adding new shares will decrease the relative value of the founder's shares (because your number of shares you have don’t relatively change)
- After a VC round, VCs will usually demand that you have an option pool for future employees so when you hire new employees they don’t get diluted. Adjusting the option pool will sometimes give you even more than negotiating more money. You can justify a lower option pool by presenting a moderate hiring plan for the first few years. Afterwards, you can negotiate to share this “pain” together with the VCs when the time comes to expand.
Tips for fundraising
- When you want to get money, find at least one more investor to be interested before the first deal is on the table.
- If you don’t have another deal to compare with when you get your first deal, it is much harder to negotiate.
- If you know a deal might be coming, you can talk with other investors and say that a deal is on its way and ask them how you can help speed up the process to get one from them too.
- Benchmark with other companies from your space that raised money to learn where the market is.
Some tips for the future…
- Your 10th and 25th reunion
- Write what you want to achieve in 10 and 25 years from now – set goals for yourself
- We overestimate the things we can accomplish in a year but we underestimate the things we can do in a decade. Think big!
Special thanks: Martin Trust Centre, MIT
Edit: Javier Rojas, 12/05/20