SOPHISTICATED FINANCE

How Entrepreneurs Think

Yesterday's post on Better Business Plans prompted a comment from Matt Winn, the VC I referenced who blogs at Punctuative. Matt said:

"Glad I could offer some blog fodder and hopeful that as more of us cover these topics, quality improves. Presentation SUBSTANCE matters a great deal as indication of how an entrepreneur thinks." (my emphasis)

While I have mentioned before that financial models and business plans demonstrate how an entrepreneur thinks about his business, I think this point deserves further clarification. When an investor evaluates management they look for four key things in addition to trustworthiness:

1. passion to succeed (and overcome obstacles) and strategic vision
2. personal compatibility (can I work with this CEO/founder) and judgment
3. analytical skills to properly understand the business and its performance metrics
4. industry knowledge

Judgement, analytical skills and industry knowledge combined probably go a long way toward defining "how an entrepreneur thinks". (May need to add a dash of strategic thinking.)

Business plans and investor presentations are the first opportunity to demonstrate analytical skills and industry knowledge to an investor. However, most entrepreneurs present what they think is just enough to get to the next step with the investor rather than full blown, analytical thinking on industry, distribution alternatives and competition. The lack of this detail is part of the reason VCs have to spend so much time to confirm the size of the market opportunity. I also think many entrepreneurs fear that they will have nothing to say at subsequent meetings if they present a complete analysis at the first meeting or in the first document. Of course, the investor having to drag information out of you may raise questions about how you think about the industry, especially when the critical risk factor only surfaces two hours into the industry discussion.

Many, many entrepreneurs also fail to properly use their financial models to demonstrate analytical skills and industry knowledge. While not all investors will read a business plan, it is rare for a financial model to go unread. The financial model is an excellent place to make clear the business model. (For the distinction between a financial model and a business model see this post.) By properly developing the business model one makes clear the growth driver(s) and the pricing and sales/distribution strategy. The key assumptions that build up to provide this analytical clarity typically also use values which can be confirmed against industry norms (further demonstrating industry knowledge).

In my definition of business model I also included capital expenditure requirements and headcount plans. Capital expenditure requirements are an excellent way to demonstrate industry knowledge, especially in telecom, Web 2.0, mining (a recent prospect) and SAAS, to name a few industries. For example, if you are presumably going to scale your Web 2.0 business, how are you going to manage the increasing need for servers and database storage. A complete CAPEX plan would make this obvious and demonstrate both analytical thinking and industry knowledge. Detailing a headcount plan is one of the best ways to demonstrate how you think about the business and your logic. Putting in 5 "C" level executives or 10 sales people the day after funding says quite different things about how you think about growth strategy and capital efficiency.

If you follow this approach to your presentation or financial model for an investor, you will give Matt and his VC industry cohorts a lot of insight into how you think about your business. And, as I said in yesterday's post, give the investors the information they want.

Excel Keyboard Shortcuts

If you have become an accomplished user of Excel for financial modeling, then long ago you probably abandoned using the mouse and do everything using key board shortcuts. An example of a keyboard shortcut is "Control-C" to copy a cell or "ALT-I" to open the "Insert" menu choices. Keyboard shortcuts are much faster than using the mouse; for those without good hand to eye coordination (like me) shortcuts are more accurate.

Yesterday I found the most comprehensive listing of Excel keyboard shortcuts at Microsoft Excel. This blog is managed by the Excel programming team at Microsoft in Redmond. Many of these keyboard shortcuts also work for other Office applications such as Word and Powerpoint. Click on the following link to download the file of keyboard shortcuts.Download Charlie_Keyboard_Shortcut_Book.xls

Modeling in Excel is not a fun task for many because it is perceived as very time consuming. Give up your mouse, learn keyboard shortcuts and it will go much faster.

The Purpose of Financial Models

I found a very good blog this weekend, Parallax: Calculating Technology's Future (definition of parallax). Mostly the blog covers trends in  software and Web 2.0 at the technical level and I had to refer to Wikipedia.com for explanations ocassionally.  In a post on financial models the writer makes the point that when he reviews a new business plan he frequently goes first to the financial model because it provides an easier way to understand the business model. The distinctions between business models, financial models and business plans are in a previous post of mine.

Financial models serve five purposes:

1. to demonstrate the size of the market opportunity
2. to explain the business model
3. to show the path to profitability
4. to quantify the investment requirement
5. to facilitate valuation of the business

From the hundreds and hundreds of financial models I have reviewed over the years I would say that most people build their models to answer question 3 or 5. The second most frequent purpose is to quantify the investment requirement (4). Of course, sophisticated early stage investors and venture capital firms are principally interested in the answers to questions 1 and 2--how big is the market and what is the business model. The business model provides the answer to the all important question--how will you grow the business.

When you build financial models the first question you should ask is "what question does the recipient of the model  want answered". The answer may change  but almost all investors want to understand the business model. Also, remember that the business model in the financial plan gives you a simple way to demonstrate again your knowledge of the industry (another important point for VCs.) Present the assumptions for the business model in a clear, logical, detailed way and you will answer a lot of the questions the recipient has and you may just accelerate the pace of your capital raise. A VC once told me that a financial model we submitted saved him two weeks of due diligence time. Never hurts to be helpful and answer the questions the recipient wants to know.

I found the blog Parallax through a post by Brad Feld.

Rants on Excel Models-II

I have refrained from ranting on Excel models since July when I posted the first rant. This new rant I attribute to preparation for my upcoming workshop on October 26 at FIU--Preparing Financial Models for Business Plans. The example  below is representative of an attempt to develop revenue detail, albeit with quite a few opportunities for improvement. It may be easier to follow along if you download the file Download september_rants.xls

The most obvious shortcoming is that the time series (January-December) is presented vertically. I have never seen a case where time series presented vertically made more sense than horizontally. First of all, every financial statement prepared by a CPA shows time series horizontally so we have been trained to understand time periods horizontally.  Secondly, the logic of the assumptions (Submitted Applications, Approved Applications, etc.) presented  horizontally is much harder to comprehend (at least for me). Lastly, linking the data on this page to another worksheet would be very time consuming (involving a manual link to each cell) because the time series data is not presented horizontally. (Hint: if you have to manually link to every cell in a series you should probably transpose the data.)

Second, this spreadsheet is designed to show the logic for revenue but no where does it indicate the revenue per approved application (one of the key assumptions). Revenue per approved application is a hard coded assumption in each row of the fourth column. Consequently, this key assumption is hidden and the model needs to be re-keyed every time you want to do sensitivity analysis on revenue per approved application.

Third, Submitted Applications drives the whole model but the values are all hard coded, basically giving you no insight into how to determine what affects the number of Submitted Applications per month. When I queried the preparer on what affected the number of applications she told me it was based on the number of offices and the number of application processors per office. This is very valuable information to better understand the business logic, but it was omitted in this model. It turns out that the number of offices is the key revenue driver that makes clear the key strategic issues in the business--how many offices can be opened and how many offices open per year. Never would have known this from the model.

The last major issue is that this model mixes revenue assumptions with balance sheet detail, making it much harder to understand the logic of the revenue detail. Separate balance sheet detail from revenue detail/logic and your models will be much more self-explanatory.

I would present the revenue detail as shown below. The file is here Download rants_1.xls

With the clarity of this presentation the revenue drivers for the business are self-explanatory. If this detail were part of a complete model I would have put each of the key assumptions in blue on a separate page with all the key assumptions for the model and linked to that page. If these assumptions had changed over time I would have presented them on the assumptions page by period and then used the VLOOKUP command to insert the assumed value in the proper period in the revenue detail. 

(Note: the Total Locations Available already exist in this particular business, are therefore a matter of fact and require no additional supporting assumptions.)

Rants on Excel Models

I have just spent the last three days re-building a very detailed client model. (Yes-I know that’s what I get paid to do.) When I first started modeling in the 1980s, people were amazed just to receive a spreadsheet. In the 1990s you had to talk people through a spreadsheet for them to understand it. Today the common expectation is that a spreadsheet or model is self-explanatory. Today, if your model is not self-explanatory, it reflects badly on the company (and the preparer).

My client’s model was not self-explanatory for several reasons:

1. There was no logic to the organization of the detail. Revenue detail was not all grouped together. For example, VAT (foreign companies have “value added tax”) calculations were mixed in with revenue and cost of sales detail even though they only had a balance sheet effect.

2. There was no balance sheet-- only a P&L and cash flow statement. This omission of the balance sheet happens frequently with models I get that are prepared by Europeans. I must assume that debt leverage (by any measure) and working capital are not concepts used frequently in Europe. (It can not be the case but their models don't make it easy to calculate!!)

3. There were color coded cells to indicate a change in an assumption instead of using date-based or period-based “if” statements. Takes quite awhile to determine why changing the assumption has no effect on the model because the timing of the assumption is hard coded. (Hint: whenever you see colored cells used anywhere in a spreadsheet except for title rows, you can safely assume that the model is not self-explanatory.)

A few tips on building better spreadsheets and models:

1. Build the spreadsheet as a stand alone document that does not need explanatory comments (or other spreadsheets that were not attached)

2. Group detail logically together. Put all the revenue detail in one section or tab. Then do the same thing for cost of sales. To improve understanding, calculate gross margins by product line or line of business. In models with multiple products, provide grand totals for revenue, cost of sales and gross margin. Going to a revenue cell on the summary P&L and finding links to 10 cells does not aid comprehension. (Hint: on the summary P&L link back to a grand total.)

3. Learn to use VLOOKUP, HLOOKUP and “name” cells instead of using "links". It makes makes it much easier to understand the model (and provides a smaller model size which passes through spam filters more easily).

4. Delete cells with values that are never used in the model. Maybe you were going to use that assumption and then changed your mind. That’s OK, but delete those cells before you send out the model. If you re-use the model, put in an on-off switch (Hint: multiply by 0 or 1) for assumptions you use but not for all cases.

5. Do not hard code numbers unless they are assumptions. Every number should be a formula or linked to an assumption. Sensitivity analysis and "what if" analysis don't work well when there are hard coded numbers outside of the assumptions.

Enough ranting. A good site for improving Excel skills is here courtesy of the Fuqua School of Business at Duke University.