SOPHISTICATED FINANCE

The Financial Summary

Daniel Cohen, an Israeli-based VC, has a good post up on how to present summary financial information in a first meeting with a VC. I always find it comforting that good practices are the same all over the world when it comes to finance, investing, valuation and due diligence.

A few of Daniel's hints:

1. You have to have a financial summary
2. Round numbers off to a significant number of digits (for example, $55,834,671.54 could be presented as $55 million)
3. Forget the graphs because VCs as a group are quantatative and don't need the training wheels of pictures; (hallelujah, hallelujah, hallelujah--maybe we could ban all graphs for ever given that most people pick the wrong chart type, don't label the axis, omit the unit of measurement, use ugly colors, etc.)
4. Present a logical scenario and avoid the hockey stick forecast

The one point that I wish Daniel had made was that the financial summary should show the growth driver(s) in the business and perhaps their economics. For example, instead of showing just new or total sales people or revenue per sales person, perhaps show EBITDA contribution per sales person. For more on growth drivers, see this post.

And remember, forget the graphs!!

Early Stage Financing Site

Through a post by Brad Feld I came across a very informative site on early stage investment, angel financing and venture capital. The site is Angel Blog and is written by Basil Peters. Mr. Peters is a former tech CEO who achieved sufficient success to become an angel investor and then started managing technology oriented hedge funds. He writes very coherently about seed financing in all of its variations. His current posts are on friends and family financing.

Before you bombard him with requests to finance your startup, please note that he is located in Vancouver and not likely to finance a startup very far from there.

Asian VCs Now Favor Consumer and Business Services Sectors

Dow Jones VentureSource reported on 1Q 2008 venture capital investment in India and China this week. China investment is strongly up and India is down compared with the same quarter last year. More noteworthy is Dow Jones' observation that venture capitalists are scaling back investment in high tech in favor of the consumer and business services sectors. This shift makes imminent sense to some one who spent twenty years working in the consumer sector in Asia. The reasons for the shift may be:

1. High tech products sold in India and China are in large part purchased by a corrupt government/military bureaucracy, which makes sales forecasting very challenging and troubling
2. Given the inherent high level of risk in these countries, perhaps the additional technology risk queered the risk return results
3. The early high tech investment was perhaps the low hanging fruit and now the real work begins to find suitable investments
4. The LPs could not understand why more money was not going into the two largest emerging middle class markets in history

I have said several times on this blog that investing in the emerging middle class is a sound investment strategy. Nice to see that the scions of Silicon Valley may be coming around to my way of thinking

Business Plans for 13 Year Olds

With the popularity of Web 2.0 and clean tech I am seeing more and more business plans in these areas.

The Web 2.0 plans almost all involve some form of social networking site and increasingly these sites are targeting more defined and narrower customer segments. This is a good trend, but fewer and fewer plans make clear why anybody would want to come to the site and more importantly use it. Everybody believes their site will go viral or Google ads will make the site a success. If it were this easy I would have already launched my social networking site for television animal personalities (I am particularly fond of the beaver with the blackberry that drinks lattes and promotes sleep medicines). Few entrepreneurs ever explain why a particular marketing plan matches their target customer or how their site will specifically match the particular needs of a target customer. Another way of looking at the issue is-- why should somebody come to your site instead of creating a group on Facebook or a social network on Ning. If you can answer these questions maybe you have a real business idea, but if all you can say is "we are going to offer better customer service, better security and videos"-- then maybe you should go back to the drawing board.These factors are not a sustainable advantage for very long, if at all. Most of the new social networking business plans I have seen recently never describe any real differential advantage. They lack this critical component because they have not developed a very profound understanding of their target customer. They have correctly picked an underdeveloped market segment but they have not really understood the customer.

The clean tech plans typically have a completely different problem. Many of them are based on carbon credits related to the Kyoto Protocol. I have yet to read a plan that relies on carbon credits and can intelligently explain how these credits get turned into cash. Last week I met with an experienced equity salesman. After my client fumbled around for ten minutes trying to explain a simple business, this old pro asked a simple question--how would you explain this business to a 13 year old. While many clean tech entrepreneurs do not yet have 13 year old children to practice on, maybe they could use this concept anyway. (Note: 13 year old rule is a good test for any business concept.)

If people can not understand the business they will not fund you.If you can not explain the concept in terms a 13 year old can understand then you have not achieved the level of simplicity required.

Tommorow I will be judging the final round of the business plan competition at the FIU Entrepreneurship Center. When judging these competitions I almost never read the financial plans unless the business concept is sufficiently well explained to merit the extra effort. Hopefully someone's presentation will inspire me to take a look at their financials. I hope so or otherwise it is going to be a long day.

A Collection of Excel Posts

In an effort to make it easier for Google searchers and readers to find the correct post they need on Excel or financial models, I have collected them here.

A reader wrote to say that they had not seen anybody give away for free so much help on Excel. Hopefully my small contribution helps.

I have also added some new sites to the custom Google search engine--Sophisticated Finance Excel--which may prove useful to readers.

Venture Capital Decision Making

Some of the most popular blogs on the Internet deal with venture capital and the entrepreneur's pursuit of such funding. Google Analytics shows that many of the readers of this blog read at least one venture capital blog. A new academic paper shows that VCs may not be articulating their decision making criteria accurately! While they obviously understand their own methodology, they may be under weighting certain factors when they explain how they make their funding decisions.

The new paper is titled Uncovering Knowledge Structures of Venture Capital Investment Decision Making and was published by Pankaj Patel and Rodney D'Souza, two PHD candidates. This paper won the SBA Office of Advocacy award for the best doctoral paper in 2008 and was funded by them. (Yes-this may be a rare example of tax dollars well spent.)

Using 144 real technology business plans, half of which were actually funded by VCs and angels, a group of experienced VCs (average 18 years as VCs) were asked to evaluate each of the 144 plans for funding based on the criteria below. The criteria was developed by the VCs and vetted using some advanced statistical techniques (which basically eliminated bias). The 14 criteria were:

1. Startup experience
2. Industry experience
3. Leadership experience
4. Management experience
5. Market size
6. Customer adoption
7. Revenue generated
8. Entry timing
9. Competition
10. Technological advantage
11. Strategy
12. Intellectual property rights
13. Value added
14. Profit margins

(Nice checklist for an executive summary or Powerpoint for a VC or angel investor.)

Drum roll--the conclusions from the study were:

1. Market opportunity (5,6,8 and 9 above) is the most important factor when VCs fund a business
2. Management team (1,2, and 4 above) is the most important factor when a business does not receive funding
3. Satisfactory team, great opportunity beats great team, so-so opportunity in the funding process

You need a decent management team to get through the first screen, but the quality of the market opportunity (market size, competitive landscape, customer buying behavior) largely determines if you will get funded. I always say that Michael Porter's Competitive Strategies: Techniques for Analyzing Industries and Competitors is one of only two books that every entrepreneur should read. Looks like the VCs may agree.

The complete paper can be downloaded through the link. Download rs315tot.pdf

Pino Spring Entrepreneurship Workshops

The Pino Global Entrepreneurship Center at FIU has planned a series of upcoming workshops for startup and early stage entrepreneurs. Details are below.

I will be presenting on Friday, March 14 and covering financial modeling for business planning. A video and the slides from my last presentation are here. All of the workshops are open to the community at large and the proceeds benefit Pino.

Why I Like Engineers

My post on the Sunshine State Venture Challenge prompted an email from a reader about the engineering student who was part of the team that won the section I judged. The reader wrote:

"Concerning your blog entry's first observation, I sat beside Agapitus Lye during the dinner banquet the night before the competition.  He is the "A" in A & D Labs, and was the 'silent partner' while Daniel Muni was delivering their presentation.  Lye is actually more than just an engineer; his is also a musician/violinist.  A rare combination.  I believe it was this fusion of seemingly disparate disciplines that led to Lye's auto-tuning instrument insight.  I think it is a testament to the traditional American liberal arts college education that allows a student the freedom to develop his or her abilities to the fullest extent while in college.  In an age of increasing specialization, this - the interdisciplinary generalist approach - should be most encouraged I think." [Note: Agapitus and Daniel won my section for an electrical device that "plays in" a violin faster than normal playing.]

Many years ago I interviewed for admission at Rensselaer Polytechnic Institute (RPI), one of the leading engineering schools in the country. During the process, a professor made a point which I have always remembered--"engineers can understand the liberal arts but liberal arts graduates can not understand engineering". [Note: I was accepted at RPI but elected to go to a liberal arts school--Hamilton College]. Another observation, from my teaching at FIU--my best business students are usually engineers. The engineers combine the ability to understand concepts with the ability to translate ideas into numbers that enhance understanding. It also appears that engineers are perhaps better trained in understanding and defining customer needs and translating it into a solution. Now let's be clear, engineering is not the only discipline that leads to good business plans and businesses that grow, but engineering training is a great way to start a business career. More Fortune 500 CEOs studied engineering than any other undergraduate discipline, which may support my point.

The reader comment above

"this fusion of seemingly disparate disciplines that led to Lye's auto-tuning instrument insight"

is actually an excellent example of what Austin defined as Type III luck. (If you do not remember my post on Austin's definitions of "luck" it is here.) Type III luck involves spotting an opportunity because you are the one person uniquely qualified to realize its significance. Lye was that unique individual who combined a knowledge of electrical engineering and the violin. The problem of "playing in" a violin has existed for centuries, but it was Lye's electrical engineering background that enabled him to see a solution. Engineering is one of those necessary disciplines that allows an individual to have Type III luck.

One closing remark to clarify--I am very much in favor of liberal arts education. A liberal arts education enriches your life by giving you the ability to understand a wide range of subjects. I just think that engineering is an excellent way to start a business education or career. I also think accounting is an excellent discipline to build a foundation for a successful business career, but my turkey is almost ready so I'll save accounting for a future post.

Happy Thanksgiving to all who celebrate!!

Sunshine State Venture Challenge

I have just returned from the Sunshine State Venture Challenge, which is the annual State of Florida university business plan competition. I was a judge and had a chance to meet Dan Rua who also judged. Dan is the Managing Partner in the Florida VC firm Inflexion Partners and his blog is called Florida Venture Blog. Inflexion is the one VC firm in Florida that consistently looks at and funds seed stage companies (and other early stage companies).

Some observations from the competition:

1. The winning plan in my section of the competition was a proprietary technology product developed by an engineering student, the same as last year. I believe he was the only student in the competition who was an engineering student and several funding sources approached him to have further discussions. Looks like we need to encourage more engineering students to enter their school business plan competitions.
2. The student plans did a very good job of defining the customer need and the concept of the solution, but plans consistently did not fully explain the business model. (A business model is defined here.) While revenue models and pricing were reasonably well developed by the students, sales and distribution strategy was frequently glossed over. To demonstrate the point, one student asked me what the difference was between "marketing" and "sales and distribution strategy". (I'll come back to this question in a future post.) It appears that statewide we may need to expand the business school curriculum to include courses on sales and distribution or business models.
3. For the third time this year I saw a student business plan for a used textbook exchange using a website. This concept never wins for a variety of reasons (weak plans to drive site traffic, Amazon and women will not meet to exchange books with strangers--to name a few). This business idea needs to be given a proper funeral or we need a student to take a completely new approach.

All in all it was a great time and very enjoyable. Hopefully they will invite me to judge again next year.

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.

Better Business Plans

Recently I have been putting a lot more emphasis in my classes and workshops on preparing business plans and financial models that answer the questions that investors want answered. Sounds like an obvious point, but most plans and models I see tend to present what the company wants you to know and not the information the investor needs. Many plans focus on presenting in meticulous detail where the founders/CEO have put their effort. For example, a company that has survived on three government research grants details every grant in minute detail or a company that has a project to develop agricultural land has four pages of maps (world, country, city and plot). (If the investor does not know where Venezuela is he is probably not deserving of a copy of the memorandum.) My favorite is the 17 pages of monthly financial forecasts with not one sentence explaining any of the assumptions.

A concise answer to what to put in the memorandum and model is provided in this blog post from a VC at Punctuative. The writer states:

"VCs tend to be extremely relationship-oriented and strategic thinkers, obsessed with high-level models, appropriate metrics, and unit economics (enough to get at the viability of a business..."

To clarify this answer in terms of what the investor wants to know (in this case a VC but generally true for all sophisticated investors):

1. You must present your strategy--customer need, target customer, market/competition, product/technology and selling/distribution strategy (a surprising number of plans fail to cover all these subjects properly)
2. You must detail the growth drivers in the business and their metrics (for an explanation of growth drivers, see this previous post)
3. You must present the revenue and EBITDA contribution at the product, customer and distribution channel level, and if using a sales force--at the sales person level  (unit economics)

If you added a sources and uses statement, management background and a good financial summary to these three key parts you would have a complete business plan in about 10 pages or less. (Add one additional exhibit for a cap table if you have existing, outside investors).

Puncutative makes another good point about the importance of a good business plan, executive summary, model, powerpoint, etc. The number of opportunities that VCs are seeing each year is increasing. Lower startup costs, not just in Web 2.0, are enabling more and more entrepreneurs to start new businesses. Therefore, the competition to get funded is getting more intense and better quality selling documents that answer the right questions are ever more important.

 

Customer Acquisition Cost

Venture capitalists strongly urge their companies to focus on getting the customer and sale and not to think in terms of marketing, branding and advertising. Part of the logic for their view is that it is difficult to clearly translate these marketing concepts into customers and sales.  A preferred way to think about the issue is to focus on customer acquisition cost--all of the costs directly related to  closing the sale.  Such an approach  makes it easy to calculate customer profitability,  sales person contribution to EBITDA, and budgets to acquire forecasted new customers (forecasted new customers x customer acquisition cost per customer). Comparing customer profitability or sales person contribution to EBITDA with non-selling overhead quickly gives one an indication of whether the selling strategy is effective. For example, if the sales person contribution to EBITDA is $150,000 per year, the non-selling overhead is $1.5 million and the plan calls for 4 sales people, you know you have a problem.

This is the method I use to determine a budget or target for customer acquisition cost:

1. determine the gross margin dollars per customer per month
2. determine the useful life of a customer in months (you may have historical data, industry standards, competitor information)
3. Calculate the expected gross margin dollars per customer (1 x 2)
4. Decide how many months of gross margin you want to invest to get the customer; multiply this number of months by the gross margin per customer per month and you have your customer acquisition cost

For example, in the telephone company I ran the average life of a customer was 18 months, we had a 50% gross margin, average customer revenue per month of $40 and we used 4 months gross margin as the budgeted customer acquisition cost. (Turned out that many companies in the industry used 3-4 months gross margin to calculate customer acquisition cost.) Now I know that I have $80 (4 x $20 gross margin), for example, to acquire each customer. With only $80 to spend to acquire a customer I immediately know I can't use a sales force, can't do advertising and probably need some sort of direct marketing approach (telephone sales, web, etc.). Alternatively, if your competition is using a sales force, you know they must have a more profitable customer than you have and you need to re-consider your product offering. (In the telephone company we started offering data lines (T1) which increased gross margin per customer 15 fold and we sold the data product through a sales force which we could now afford. Customer average life also increased because the customers do not switch data suppliers as easily as they switch voice.)

So--no more discussion of marketing, branding and advertising until revenues reach $30 million--and let's focus on customer acquisition cost.

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.

Florida Venture Capital--V

I have just heard that HIG Ventures, the largest venture fund based in Florida, has changed their investment focus. Rather than investing at all stages of development, HIG is now targeting companies with $10 million in revenue. This shift in focus perhaps suggests that the number and quality of earlier stage companies in Florida did not meet HIG's original expectations. It is equally likely that HIG believes they can generate better returns by investing in later stage companies. Also, this new focus means that companies that are too early for HIG's private equity funds better match their venture fund's focus.

This change in focus leaves startup entrepreneurs with only Sunrock as a South Florida based venture capital fund looking at startups.

New Venture Capital Firm in Miami

TechJournal South reports that Miami has a new venture capital firm--Sunrock Ventures. They have a $100 million fund that will consider investments at all stages of development including seed. Based on the experience of the three Partners, the fund will probably be particularly interested in IT, software, bio-medical devices, communications and financial services. Too bad they do not appear to have any experience in cleantech or Web 2.0 but let us all applaud their interest in looking at seed stage deals.

One thing that is noteworthy is the investment thesis in raising the fund. They correctly observe that Florida is underfunded for venture capital (Hint: less competition) and therefore they should be able to invest their capital at better valuations and thereby generate superior returns. Don't expect flush valuations from Sunrock. (My thoughts on the shortage of venture capital in Florida are here.)

All venture capital firms live on their deal flow. Sunrock targets to close 6-8 deals per year. They have to look at a lot of deals to close 6, but the good news is we have another firm looking. About 2-3 more new venture capital firms and we should have real support for the early stage companies here.

Latin American Startups Entering U.S.

I get quite a few inquiries from early stage companies in Latin America asking for help to raise U.S. venture capital money for entry to the U.S. market. The inquiries usually come from Brazil and Argentina, which is a little surprising given the vibrant VC community particularly in Brazil. The companies usually profile as follows:

1. Family or angel backed
2. Sales of US$3-4 million
3. No sales outside their home country
4. Seeking outside capital because of concerns about the cost to enter the U.S. market
5. No obvious product link to the U.S. (unlike some of the VOIP services)

I usually give the following advice:

1. First expand into a market in Latin America to demonstrate new market entry expertise and that there is a market outside the home country
2. Consider an aggressive expansion in Latin America; it may be more capital efficient than the U.S. and easier to manage because of distance, culture and customer knowledge
3. If you insist on entering the U.S. market, start with either a distributor or a sales rep network to prove in a cost effective way that the product can be sold here
4. You have to have a real presence in the U.S. and senior management committed to working in the U.S. before any VC will consider your opportunity

The real strategic error is that these companies are too small to be considering international expansion. No market in Latin America is sufficiently penetrated when sales are only US$ 3 million. In a previous post on the stages of business development I discussed that breaking through $3 million in sales is a critical hurdle in demonstrating that a company can scale. Most of these companies are considering international expansion because they have not figured out how to scale in their home markets. They have commercialized the product but have not figured out how to scale the business.

If you have not figured it out yet, early stage U.S. companies should not be considering international expansion when annual revenues are $3-4 million. You too should be focused on scaling your business in the U.S. At this stage foreign markets are an expensive distraction that will probably guarantee that you never achieve any meaningful market share in the U.S.

Startup Business Plan Development

I have been working with my friends and colleagues at the FIU Pino Entrepreneurship Center  to revise their workshop series. The workshops are offered to both students and local entrepreneurs to help them develop financeable business plans and are a key part of the preparation for the annual student business plan competition. The challenge in the workshops is to bridge the gap between the theory of the college classroom and the practical requirements of funding sources. What we are working on is a flowchart that demonstrates the process of developing a business plan and how the workshops support that process.

At the same time I have been reading the works of Clayton M. Christensen, the HBS professor who coined the term "disruptive technologies" and has written extensively on innovation and strategy. After coining the term, subsequent thinking led him to use a new term- "disruptive innovations". Christensen realized that it was business strategies and business models that created the disruption and not the technology alone.

The distinction between a business strategy and a business model is particularly important and appears to be frequently  neglected in most of the business plans I see.  A business strategy deals with the allocation of resources and I would define it as "the allocation of resources to increase shareholder value in an economically efficient way".  The key resources are capital, people and time.  The business model is the practical translation of the strategy and focuses principally on  the revenue model, pricing and selling strategy required to achieve the growth objectives of the strategy. I also like to develop a headcount plan and a detailed understanding of capex in the business model given that they are frequently the largest requirements for capital.

With Christensen in mind and some input from Sequoia Capital's website, I have developed the flow chart below to explain the process of developing a business plan. This is a work in progress and I welcome comment. The descriptions that follow are intended to be illustrative and not comprehensive.

The process begins with the recognition of the customer need and then the formulation of a conceptual solution. The solution is then tested and refined by developing a business concept. The development of the business concept is an iterative process, meaning that any of the analysis in one of the four boxes can cause another part of the concept to be re-done. For me, business concept starts with identifying and defining a target customer with the identified need. The customer is then understood in the context of the market. (Michael Porter's Competitive Strategy is perhaps the definitive work on this type of analysis.) In this section of the analysis the all important question of market size should be determined, particularly given that it is one of the most important questions for venture capitalists. Next is the section on competitive analysis with particular attention to alternative technologies and distribution channels. Classic product definition is the next step where one defines the product features and benefits. The description and understanding of applicable technology, if any, and the related technology risks are the last part of preparing the business concept. After completing the business concept one should be clearly able to articulate the differential advantage, the unique set of features which will sustain the business.

I find that many people complete the development of a business concept and then skip right to the financial model. This approach frequently leads to very uninformative financial models. The financial models serves many purposes, not the least of which is to provide another opportunity to explain your business model and your logic for managing the business.

When I first learned to develop financial models (using a slide rule) I was taught to begin with the revenue assumptions. Revenue assumptions are now called "revenue drivers" and form the foundation for the first box in developing a business model--the revenue model. Growth in revenue comes from five alternatives or drivers:

1. new accounts (B2B)
2. new locations (retail, restaurants, etc.)
3. new subscribers (telecom, cable, websites)
4. new distribution outlets (think Haagen-Dazs)
5. sales people (business services, B2B)

While the differences in the five alternatives may be subtle, each alternative has a different cost structure related to it. Fully explaining the assumptions behind any of these alternatives produces a revenue model. This "management logic" is, of course, showcased in the detail of the financial model also.

Another often neglected part of the overall analysis is the next step in business model development- pricing analysis. Rarely do I see business plans that show the sensitivity of gross margin or EBITDA to different outcomes in pricing or different pricing strategies.  Bad pricing assumptions are one of the most frequent causes for companies to exhaust their capital prematurely.

Selling and distribution in the business model is the implementation plan for the selling strategy (how to get the customer) and would include the assumptions and expenses related to supporting your revenue drivers (in the revenue model). Customer acquisition cost or EBITDA contribution per sales person would be key assumptions developed at this stage. The sales person staffing for each new market would also be included here.

The next step is to develop a headcount plan. Headcount demonstrates the plan for adding staff by position by date. Metrics for adding customer service staff or a time line for adding programmers or R&D staff would be included. Growth in sales people developed in the last step would be transferred here to complete the headcount and salary and benefit assumptions by position complete the analysis.

The last step in the business model-CAPEX-highlights the recurring capital expenditures, whether it be store cost, routers and trunks for an ISP, or the cost of furniture, software and computers for customer service staff. Again, we develop metrics where applicable. At the conclusion of the business model analysis one should be able to clearly articulate the growth drivers in the business. (If the capital required for the business is not being invested in the growth drivers, one is well advised to re-work the business model or the financial plan.)

With the business model detailed and completed, developing the financial model becomes very easy because all of the key assumptions, except capital required, have been developed. The P&L, balance sheet and cash flow statement are prepared based on accrual accounting according to GAAP or IFRS. The level of detail in the P&L should generally match the level of detail in the business model, although overhead expenses will need to be further developed here. Developing the Sources & Uses is a usefully method for determining the capital requirement. Sources & Uses are discussed here in a previous post.

The last step in the process is to determine the feasibility of the project. We are seeking to determine the capital efficiency of the proposed new business, both on an IRR basis and in terms of return to investors. Should either of these measures fall below accepted levels, as shown in the diagram above one does not go back to the financial model but instead returns to the business concept or the business model. Changing key assumptions in the financial model alone, without considering their impact on the whole business model, is a poor method to refine a business plan.

On October 26th I will be giving an 8 hour workshop at FIU on building financial models. The workshop is open to the public. A small fee goes to the Entrepreneurship Center. Details can be found here. The workshop focuses on using the business model to develop the financial model and there are lots of real examples to illustrate the points.

Florida Web 2.0

In the late 1990s I was the CFO of an Internet startup in Florida. At that time Miami was abuzz with countless new startups all trying to mine the Internet space. Few succeeded but many tried. Today, with Web 2.0 creating a frenzy similar to the late 1990s, I find many fewer entrepreneurs in South Florida trying to participate. Perhaps the more sophisticated technology now required is a barrier to entry or perhaps we lack sufficient programmers and developers, as some people say. (Personally, I would look to Latin America if human resources were the issue.)

The lack of South Florida participants in Web 2.0 is particularly surprising given that the capital required for a Web 2.0 startup is probably only 10-20 percent of the costs of an Internet startup in 1999. Facebook announced yesterday the formation of the fbFund to provide $25,000-$250,000 of capital to developers building applications on Facebook. Facebook is also reportedly considering to host these applications, which reduces the infrastructure risk in scaling and the related requirement for larger amounts of capital.

Accel Partners (investors in Facebook) and Founders Fund (managed by the founders of PayPal) are reportedly providing the initial fund capital of $10 million. While seed investing by venture capital funds has been largely out of favor for several years, I see the Accel involvement as further evidence that the larger funds are once again looking at ways to do seed investing. (Founders specializes in seed stage investing.) Secondly, I expect more of the large social networking sites to follow Facebook's example and start funds to support applications developers. (I hope LinkedIn creates a fund because they desperately need some new apps/features to insure continued subscriber interest.) Lastly, the fact that the fund is only $10 million just demonstrates the comparatively small amounts of capital required for a Web 2.0 startup.

Will fbFund do anything to support startups in Florida.....probably not. Will Accel's involvement at the seed stage do anything to increase the capital directed to startups by the venture capital industry......let's hope so. Will any of this do anything to help Florida Web 2.0 startups.......no! However, I am making progress on that front and will be reporting back to my readers shortly.

Best Blog: The VC Perspective

For all of my current and former students interested in better understanding startups and venture capital, I think the best blog to read is not Brad Feld, Guy Kawasaki, or even Ask the VC (all of which are excellent blogs). The best blog to read is Will Price's blog. Will is an associate at Hummer Winblad, the venture capital firm based in San Francisco that specializes in software. The reason that I like the blog so much is that he frequently writes about the analytical approach that his firm uses to select their investments. Many write about the finance side of venture funding but few provide consistent insight into the process and techniques that VCs use to evaluate opportunities. Will's post today is an excellent example of his writing and a must read to better understand the VC selection process.

All of the concern about valuation, liquidation preferences and exit multiples written about in blogs is moot if you can not get a VC interested and sustain that interest through due diligence. Reading Will could be very helpful to improving your chances to a get a meeting with a VC and survive due diligence.

Another excellent resource to better understanding the analytical process of VCs is this page on the Sequoia Capital website. If Kleiner Perkins is the Golman Sachs of venture firms then Sequoia is Morgan Stanley.

VCs-They are Not all Monsters

Yesterday I met with an executive at a company where I had helped arrange their A round of venture capital. I was interested to hear about their dealings with their two VC firms one year after funding. Contrary to what you read on many blogs, this executive was very positive about his two VC firms. The VCs had not been overly intrusive, had not required excessive reporting and only met with the company periodically. Of course, it probably helps that the company is on plan and the CEO is clearly focused on new business development. In my experience VCs become excessively "intrusive" when companies fall behind plan and the CEO is fighting the changes that need to be made. The more the CEO fails to recognize the need for a new direction, the more pressure the VCs assert.

One thing the company I visited is doing is using programmers and developers based in Latin America. Off shore programming staff now totals fifty full time people. While India is the fashion in offshore programming, this company chose Latin America because of its geographic proximity, the greater cultural similarities which facilitate better communications and the programmers personal familiarity with the U.S. market. The company uses once a month, on-site visits to keep everything on track. (Who wants to go to India once a month?) I have dealt with a lot of technical people in Latin America and I have found them to be the equal and often better than what I see in Miami. Outsourcing technical work in Latin America makes a lot of sense to me, and for those who do not speak Spanish, a lot of people now speak English well.