June 2003 How do we make money? Financial management, valuation and financing Douglas Abrams -...

June 2003

How do we make money?

Financial management, valuation and financing

Douglas Abrams - Parallax Capital Management

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Douglas Abrams - Parallax Capital Management

How do we make money?

The business model

Financial management

Forecasting and valuation

Funding required and equity offered

ROI and exit strategy

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Douglas Abrams - Parallax Capital Management

Determine the business model

How do we create value?

Who do we create value for?

How do we differentiate ourselves?

How will we make money?

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Douglas Abrams - Parallax Capital Management

How do we make money?

The business model

Financial management

Forecasting and valuation

Funding required and equity offered

ROI and exit strategy

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Douglas Abrams - Parallax Capital Management

Determine your needs

Think about your income and cash needs

Think about your sales and funding needs

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Two ways to look at your finances

Operating view - budgeting – Operating budget– Cash-flow budget

Accounting view - forecasting and valuation

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Expense and operating budget

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Cash flow budget

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The Path to Profitability (P to P)

What is profitability?

Startup can fund all operations from cash flow

How much investment needed until then?

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The burn rate and months remaining

Methods of calculating the burn rate– GAAP– EBIDTA (before interest, depreciation, taxes and amortization

Calculate months remaining– Remaining months liquidity – How many months worth of cash does the company have left?

Multiple burn rates may be required to reach milestones until startup can fund from its own revenues

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Principal financial statements

Balance statement - the company’s financial condition

Income statement (P&L) - the success of the business

Cash flow statement - cash availability and needs of the business

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Balance statements must balance

Economic resources of the company

Ability to provide future benefits to the firm

Cash

Inventory

Equipment

Left side - Assets

Liabilities - creditor’s claims on the assets of the firm

Accounts payable, bonds payable

Shareholder’s equity - the owner’s claim on the assets of the firm

Contributed capital

Retained earnings

Right side - Liabilities & Equity

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Why is financial information important to entrepreneurs?

No cash, no business

Financial information pulls together all information presented in the other segments of the business; marketing, manufacturing & management

It quantifies all assumptions & historical information concerning business operations

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Douglas Abrams - Parallax Capital Management

How do we make money?

The business model

Financial management

Forecasting and valuation

Funding required and equity offered

ROI and exit strategy

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Douglas Abrams - Parallax Capital Management

Forecasting requires predicting the future

Yr 1 Yr 2 Yr 3 Yr 4

Gross Revenues

Operating Expenses

EBITDA

Metric: Ex: Units sold/leased

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We predict using pro forma financials

Three to five years of:

Income statements

Balance sheet

Cash-flow statement

P&L

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Preparing your forecasts

Project from bottom up

Sales growth and market share are key

Project cash requirements

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What is the value of a firm?

Fundamental value?

Technical value?

Balance sheet value of assets?

Market value of assets?

Multiple of book value?

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Company valuation methods

Price to earnings (p/e)

Dividend yield

Multiple of book value

Comparables

Discounted Cash Flow (DCF)

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Comparables

Use value that has already been established either in public markets or through a sale for a comparable company

Difficulties– How to find comps– Accounting methods vary– Public versus private liquidity– Changing market conditions

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DCF Valuation Model

Firm value is discounted present value of future cash flows

Percent of sales forecasting

Tie income-statement and balance sheet figures to future sales

Variable costs and most current assets and liabilities tend to vary directly with sales

Only future sales require prediction; relationship between items can be calculated more easily

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Discounted cash flow

Project cash flow from operations for 3-5 years

Adjust the cash flow for factors such as non-recurring items of income and expense, depreciation, amortization, interest and taxes

Discount the cash flow as adjusted, using alternative assumptions for time and risk factors.

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What are our time, scope and size ambitions?

Subsistence model

Income model

Growth model

Speculative model

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Scalability and its costs

Scalability necessary for VC investment

$300MM gross profits within 5 years

Scalability is expensive - marketing, infrastructure, etc.

Demonstrate need and value of product or service with $3MM? Get to break even with less than $20MM with yearly revenues of $100MM in 5-10 years

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How do we make money?

The business model

Financial management

Forecasting and valuation

Funding required and equity offered

ROI and exit strategy

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Douglas Abrams - Parallax Capital Management

What are sources of funds?

Profits/Retained earnings

Equity

Debt

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Funds needed

How much does the company need?

What percentage does the company want to sell?– Often too much or too little– This is the wrong question

Set performance and fund-raising milestones– How much money do you need to achieve the next milestone?– Divide defensible firm value by funds needed to determine

percentage to sell

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Sources of funds

Own money (OM)

Friends and Family (F&F[and Fools]) Angels

Incubators

Corporations

Customers, suppliers, lessors and strategic partners

Government grants and investments

Banks for VC loans

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Uses of funds

Be detailed

No big salaries for founders

How will these funds be used to fuel necessary growth?

Sufficient funding to reach next financing milestone

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Funding stages

Founder’s capital

Seed/Angel

Series A, B, C

Mezzanine

Pre-IPO

IPO

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Pre-money valuation

Worth of the business before VC investment

Amount invested by VC divided by– Agreed pre-money value of business + – Amount invested by VC = equity owned by VC – VC receives equity share based on post money total– $3MM pre + 1 MM VC = 25% VC equity

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Douglas Abrams - Parallax Capital Management

How do we make money?

The business model

Financial management

Forecasting and valuation

Funding required and equity offered

ROI and exit strategy

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Douglas Abrams - Parallax Capital Management

VC hurdle rate

Minimum yearly compounded rate of return VC expects from investment (risk assessment)

Seed stage 60-100%

Early stage 60%

Late stage with profits 40%

Bridge financing to cash out 20%

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Why are VC’s hurdle rates so high?

VCs must deliver above-average returns to their investors

Percentage of winners and losers– 20/80 at best

Overall return required by VC investors 30/40%– Do the math

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Post money valuation

Used to estimate the price the business must command at the liquidity event

If liquidity event is sale in 5 years, and hurdle rate is x%, can calculate sale price required

$4 million post money; 50% hurdle rate

Sale price must = $30 MM

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Calculate VC’s Projected ROI

Take projected earnings from DCF model in exit year

Multiply by comparable P/E multiple for industry to calculate price

Multiply by VC’s equity percentage at exit to calculate VC’s share

Divide VC’s share by original investment

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Exit strategy and market conditions

Liquidity event– Convert private equity to cash or freely tradable stock – Sale or IPO– Merger with public company– Back-door listing, – Reverse merger

Within 3-5 years

Only 10-15% of liquidity events

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Douglas Abrams - Parallax Capital Management

Contact us

Douglas Abrams

Managing Director

Parallax Capital Management

dka@parallaxcapital.com

www.parallaxcapital.com

65-6238-3492, 65-9780-5381 (hp)

390 Orchard Road, #11-01 Palais Renaissance, Singapore 238871