What creates revenue?

This should be very simple as in the example I have provided. It should be some “units” time average selling price (ASP). ASP is the average amount of revenue that you receive per unit. This is after discounts and commissions you pay to resellers. It is the actual money that flows into your bank account.

What do you mean by “Units”?

This can be a bit trickier than it might first appear. Units can be the number of products sold.

However, it could and more properly (for future calculations) should be one average customer. If an average customer buys only one product, then these two are the same. On the other hand, if an average customer buys 2 products, then they are not the same. The model would get a bit more complicated like below:

You are probably thinking, why does it matter? It does. As we get later and we are analyzing our marketing and sales costs, we are going to do it on a per customer basis as opposed to a per unit basis so we need both the number of new customers (for the future) and the number of new units (for now).

What is the average revenue per unit?

In the case above, the average revenue per unit is based on the customer. Let’s look at one quarterly example for the first quarter of the second year. The ASP for the product this quarter is $350 but since the unit is an average new customer, the average revenue per new unit is $700. This is because, in this quarter, we are projecting that, on average, a new customer will buy two of our products.

This may seem a bit more complicated but it is important to set us up to understand the unit economics involved with LTV (Life Time Value of an average customer) and the COCA (Cost of Customer Acquisition or also often called CAC, Customer Acquisition Cost). These are important lenses through which to analyze our business and we want to make sure our model is aligned with them.

It is helpful to see the size of the total BHM in units/customers so you can quickly understand market penetration

Another piece of information that you should have available and I actually like to include in the modeling is the size in units of the target market you are addressing. This should not be your basis for calculating your revenue projections (that should be “bottoms up” with specific customers) but rather a “sanity check” that they are reasonable.

In this case, it is the BHM and not the overall market (we will add the overall market later once we have this done).

As you can see now in the last row, there are an estimated 5,000 customers in their BHM so getting 500 in a year is put in a much more concrete perspective. Is 10% reasonable in one quarter or not? It depends on the nature of the market. This number also tells you that by the end of year three you expect to have over 900 customers within this market which is almost 20% of the market. Is that reasonable or not? It depends on the marketplace dynamics and the strength of your product but this number gives important context.

It also gives an indication of when you will reach saturation in a market, in this case, your BHM.

There can be a case made to not crowd the spreadsheet with this number but rather note elsewhere, e.g, footnote, comment, backup, or verbal comments. There certainly is a benefit to keeping things simple but whether it is on the spreadsheet visible in your model or not, you need to know this number and explain it at some point.

Level of Precision

As mentioned before, critics of models will say “they are never correct!.” That is true from a precision standpoint but it does not mean they are not useful. They can certainly be both not precisely correct and very valuable. However, there is a very valid point that you should not get caught up in a level of precision that you cannot know and such specificity is not useful, like the exact numbers of new customers in the third quarter of the third year.  You should come up with a reasonable number and be able to justify it. The closer in time you are to your numbers, the more precision you should have. For instance, if you are projecting the number of new customers in the next 30 days, that number should be quite precise and you should be able to back it up with great specificity. It is still a forecast as it is in the future so it is not a certainty but you should have confidence and resolution that you will not have for a forecast on the number of new customers in year five. In year five, it is not only a good way away in time but you will also be layering on additional markets beyond the BHM for which you have not done extensive PMR (Primary Market Research).

In the near term, you should have much higher confidence and rely on specific bottom-up information you have collected directly via PMR and selling efforts already underway. In the long term, you will depend more on secondary research. As such, as you get into the out years, make sure you don’t indicate precision on the numbers that you obviously cannot have. You will lose credibility and waste time.

Even in the short term, don’t waste too much time on the precise numbers but rather get to the general numbers and ranges … and what drives those numbers. Remember, your goal is to have a valuable model less than having a precise model. The former is much more attainable in a reasonable period of time and the latter could be a sinkhole of your time for something that will never be possible. All of this being said, build a good defensible model that explains your business and don’t use the “it will never be right” excuse to not build a useful model.

How do items in our model vary over time?

So far, we have only discussed how a few things would vary over time, like the ASP for the product. If things are not going to change much, you can just leave them constant but if they are going to change materially, you should look at incorporating positive or negative growth rates. The ASP showed a positive growth rate in the simple example model we have been discussing as we gain pricing power from our customer successes. We also see the number of units purchased by customers increasing, as they get more confident in our solution.

What could experience a negative growth rate? The number of customers in our target market might decrease due to consolidation or other market factors. We might see a decrease in ASP as competitors flood the market after they see our success or our patent expires. I would encourage you to not get caught up in these things at first as you build your model but leave the ability to add them in later as you refine your model.

What is the lifetime of a customer and/or product?

As you build your model, other questions will continually arise but one that will arise very quickly is, “what is the lifetime of a customer and/or product in your situation?” How long you will retain a customer will affect the follow-on revenue that you will get from that customer. This includes whether they will be a replacement product if the current product becomes obsolete from use or advancement of technology. Think of the Apple iPhone. If you are a loyal customer of theirs, the product lasts about 3 years (give or take). If they stay a customer, that means they will buy a new product from you every 3 years on average. That would then also be built into your model.  This leads to the discussion of retention rates and churn, which become very important as your model becomes more sophisticated, but you don’t need to worry about this now at the beginning but know it is coming.

What if I have a different type or type of business model to generate revenue? (e.g., one-time charge, recurring revenue, transaction revenue)

What you do need to know at the beginning is the various types of revenue. This model assumes only simple “one-time charge” revenue. That is very nice in that it makes the model easy. It is also well accepted by customers and the most common form of revenue. This however does not mean it is the only and certainly not necessarily the best for you and your customer. In fact, the “one and done” model has some problems but it will never go away.

The “recurring revenue” business model or subscription model has become very popular driven by the boom of SaaS (Software as a Service) and its successful evolution. It is here to stay and investors, customers, and vendors generally love it. It has even spread to other non-software industries. It produces a steady stream of revenue for your venture that is predictable and robust against recessions and other economic fluctuations. Investors value this type of revenue much more highly than one-time revenue and customer may like the fact that they don’t have to pay upfront and they can depend on continual updates to their products. They may pay more in the end, potentially meaning a higher LTV, but they often are willing to do so.

Another major business model is the transaction business model where the customer pays based on their usage. Think of an electric utility and how it charges us. The consumables business model is also really a variation of this. You buy the razor but the more you use it, the more blades you use. Likewise for your printer. The more you use it, the more ink you buy. Again, for a certain customer base, this is very attractive and generally accepted as the norm of business.

This has not been incorporated into our simple model but it could be as below as another section like the “One Time” and “Recurring Revenue” sections.

Notice that you can combine business models, and businesses often do. The customer, in this case, is paying upfront for the product but they also pay a maintenance fee, which generates recurring revenue. In this case, the recurring revenue is proportionally small compared to the one-time revenue ($64K vs. $937K) but it can be much larger for other businesses. As stated previously, the recurring revenue has many very attractive characteristics and is highly valued by entrepreneurs and investors so don’t overlook this source. You should also look to think of creative ways to increase this stream of revenue.

It is definitely simpler if it is only one type of business model and if you had your choice, you would likely pick the subscription model. It would make the modeling much easier. That said, the subscription model is not without its weaknesses and each business model has its strengths and weaknesses. You have to find the best mix for your situation.

Also note that there are other business models that would make your financial revenue model more complicated like advertising, affiliate marketing (e.g., getting commissions), selling access to data, franchising, and more (see step 15 of the Disciplined Entrepreneurship 24 steps for a lot more details). All of these could be modeled and the principles are the same but it just gets more complicated.

As you have seen on this website, I have been releasing draft chapters for comment from the upcoming Financial Literacy and Fundraising for Entrepreneurs book I am working on. Based on feedback and just looking at the length and complexity of the next chapter, I am now planning to release more bite-sized parts of this next chapter (Chapter 3 – Financial Modeling). In this way, I feel it will be more easily and widely processed and feedback can be more focused. In this vein, here is the first part of Chapter 3 for your review and comment. As always, please don’t feel you have to sugarcoat your comments – “critical feedback is the breakfast of champions” is our motto.

By the way, related to this work, there is now a free online edX course, Fundamentals of Entrepreneurial Finance: What Every Entrepreneur Should Know, taught by myself with my MIT faculty colleagues Antoinette Schoar and Matthew Rhodes-Kropf. I welcome your comments on this too!

What is the purpose of a financial model?

In this chapter, we will teach you how to develop a model to generate projections of your business that provides insights, meaningful projections, a potential path to greatness, and a planning tool. I have heard intelligent people say “meaningful five-year financial projections?!?! – come on! They are surely going to be wrong. How can they be meaningful?”

It is correct that they will be wrong but that does not mean the process of building the model as well as the model itself are not useful and extremely valuable. They will be valuable to you, your team, and other stakeholders. To start with, it will force you to understand what key assumptions you must make to derive the revenue, costs, profitability, growth rate, and other factors that will determine your cash flow – a cash flow that needs to be positive for you to continue to exist. A well-designed model is explicit about what assumptions you are making to build your projections.

The skeptic is correct that all of the model projections will not be 100% correct but they will be correct if all of your assumptions become precisely true, which never happens. That being said, this work in trying to quantify the future will give you great insights into what factors are most critical to your financial sustainability and success – and which ones are less important. You will also have a model and you can adjust to see what the new projections look like as you get more information to more accurately forecast key assumptions. In summary, the thought process and a well-designed model will make it clear what are the key drivers of your business to make it economically viable.

Also extremely important, the model should also show you if a path to greatness is possible, and if it is not, then you shouldn’t do the new venture unless you are willing to give up this hope. There should be some set of assumptions that make your business not just financially viable but attractive and highly impactful. Financial projections help to show if the venture will be able to have the level of impact that motivated you to create the company in the first place. The time, effort, and resources required to build this new venture should be worthy of the opportunity cost it will take to build it. This question is not asked enough by entrepreneurs, educators, and mentors. It is not just enough to survive. You want to maximize your impact.

Making clear what your assumptions are and being able to adjust them to see the impact is central to building a helpful model. It must be simple enough to understand and modify but also capture enough of the complexities of your business.

The Sequencing of Building a Model

Start with modeling the top-line (revenue) and then do expenses.

We will start with revenue first because, without revenue growth, nothing else matters. If you can’t produce sales growth and scale, you can’t solve the problem on the expense side.  All revenue curves basically look the same – up and to the right. No shame in that. You don’t want them looking any other way. If they are flat, that is no good. If they are headed downward, run!

Once we have built the revenue model and iterated on it such that we are comfortable with the model’s logic, its assumptions, and ultimately its overall numbers, then we will focus on the costs and build up that part of the business model.

In this chapter, we will build the model in three steps. First, we will build the revenue model to understand revenue growth. Secondly, we will add the costs into the model. Lastly, we will build a summary of the model to make it easy to understand the key points. The last step is very important. You must be able to crisply communicate your financial model, current projections, key assumptions, leverage points to watch for, and the path to greatness.

Building a Revenue Model

Start with your Beachhead Market (BHM)

The first part of building your revenue model should focus exclusively on your beachhead market (BHM). This will make the task clearly scoped and much more achievable. It allows for specificity that you will lose as you move on to other markets that you have less information about. That specificity should give you more confidence you are building your first model correctly.

Later we will add a layer on top of this BHM revenue projections follow on markets but you should begin with a focus on the BHM. It makes the job a lot easier to get started.

When Does Revenue Start to Come Into Your Company?

The first question will be, when do you start to get customers? For some, they can get paid by the economic buyer for the MVBP they produce right away. This can be a good thing because you want to test the customer’s willingness to pay. You can always change (hopefully increase) the price later as you prove your value proposition. As time goes on and you are successful in the market, it also decreases your risk as a vendor which will allow you to raise your prices or more likely, decrease the amount of discount you give out to get a sale. Decreasing your discounts has exactly the same effect as increasing your prices and is generally a better way to achieve the same goal. Your model should be built to allow for increases in pricing (or decreases in discounting but going forward that will be implied) by month, quarter, or year.

Here is a very simple example to show how to get started:

Notice this model is just focused on the BHM which makes the problem much more reasonable to address. Secondly, you don’t have to generate revenue immediately. It will take you a while to develop your product and get your first customers. Once you have that first customer, you will likely have to or want to give them a discount as you work out the kinks in your product with them.

The number of customers will start small as you refine your product and build your value proposition and company capabilities as well as market presence to be a respected vendor. As time goes on, you are able to dramatically increase the volume of customers that you acquire while also increasing the price.

This is due to the increased validation you have received in the marketplace from your initial successful installations (they had better be successful!).

So, in this simple model, revenue starts in the third quarter of the first year. It is not much but it is the starting point. When does the revenue start for your new venture? If you are developing a medical device that requires a lot of technological development, product development, and regulatory testing and approval, this could take years, which is painful but it is what it is. You might have a mobile app that you can put together an MVBP in a matter of a month so you might be able to get your first paying customer within the first month or quarter. As you can see, it will vary widely based on your situation and industry.

How much should I charge at the beginning?

As you can see from the model above, in the beginning, the price is very low ($250) as compared to what it is projected to be three years later ($750). Why is that? This is because at the beginning, you don’t have pricing power and you want to have customers who are more forgiving as you iterate to improve your product. You have not yet proven your value proposition in the market place and you are seen as a risky vendor. Rarely does a person or organization want to be that first customer (it is very risky to be first) so you have to give them some incentive. You would generally do this by giving them a discount. It is almost always easier to have a high list price and give people a discount and then later decrease the discount you are giving people than to raise the price. You can raise the price but you generally want to do this with a release of a new product with a lot more functionality (e.g., iPhone 10 to iPhone 11s with a new camera). Increasing the list price on the same product is a tough sell often to customers as they are conditioned to the previous price. Hence, decreasing discounts is a less conspicuous way to increase prices if you can do it properly.

There can be a case for not charging customers, especially end-users who are not the economic buyers, at the beginning. I must admit, I am not a big fan of this except in extreme cases. You have not proven one of the key elements you need to in an MVBP if you do not charge, that is the economic buyer’s willingness to commit to paying something. If there is no skin in the game and the product is free, have you really proven one of the most important hypotheses of entrepreneurship, i.e., that you can extract rent for the value you have created? No. That is why I am generally skeptical of this approach.

That being said, if your business is a platform or one that depends on monetizing the data collected from lots of end-users, it is virtually impossible to get the economic buyer to pay until you have acquired users. This is really the exception to the rule but it should not be used as a cop-out for others to avoid gaining a commitment from the economic buyer to pay something (it does not have to be full value to start) for the value you are creating.

Behavioral economists have shown it is very hard to get people to pay for things that they have gotten for free historically. It is hard enough to get them to increase the amount they pay but it is much worse to get them to pay anything when they have paid nothing and the mental model they have is that the product or service is free.

So my advice is to charge the economic buyer(s) something as soon as possible and then increase it over time as you prove your value proposition and your company. At a minimum, call it a “free trial period” so you can go back and extract rent at the end of the trial period.

In this chapter, we will teach you the basics of finance without all the details. Think of this as Financial Literacy which is not going to earn you a degree in finance but it will give you the fundamentals so you know how to run and keep track of your business. We will dive into these high-level concepts as we move forward, especially in the modeling phase which will come next but for now, let’s just level set on the most foundational concepts and then build up from there. We will focus on operational concepts as opposed to accounting concepts for now.

From an operational standpoint, the most simple level for finance is cash in, cash out, and net cash flow.

The simple link between these is

cash in – cash out = net cash flow

Notice I am not yet using terms like profit, sales, expenses because these all have very specific accounting meanings and we will get to them but for now, as we said in chapter 1, cash is oxygen and if don’t have cash, we die. As an entrepreneur, you always need to understand the cash first. Cash is the ultimate measurement you must be concerned with. We will talk about many specific financial statements for a business in this chapter (the three most popular are income statement, balance sheet, statement of cash flows) but I always say the most important statement for an entrepreneur is the bank statement. This is because; while incomplete for sure, it is very real and tells you how much cash you have in the bank. That is a good starting point. As you will see, each financial view of your business has strengths and weaknesses. The bank statement is very easy to understand and it is very real which is it strength. Its weaknesses are that it is just one point in time and even then it does not give you insights into obligations and assets that you have at that point in time. It does not tell you the rate at which you are gaining or losing money either because it is just one point. The trend, or rate, at which you are gaining or losing cash is captured most simply in the statement above when we add the implied assumption that it is for a period of time (often a year but it could be a month or a quarter or whatever is chosen):

cash in – cash out = net cash flow for a period of time

You now might say that this would represent profit, but that is not correct. You might say it represents your company’s cash burn rate which would be closer to the truth but still not correct. Cash burn rate would be the rate that your business would expect to be running at without an extraordinary transactions related to cash.

As we have defined cash in so far, it is all cash that comes into the company – which could be from normal operations and continual sources of money. What would not be normal would be a onetime transaction where you received money. This cash that resulting from fundraising, a sale of an asset of the company, money received in a legal settlement or any other unlikely to recur event. Likewise, the same is true for cash out where onetime transactions might be things buying a significant asset like a computer, a legal settle you had to pay out, non-recurring marketing campaign, a signing bonus that you don’t think you will have to pay in the future to hire people, severance package and the like.  If you can take all of those onetime transactions out, you will get to what is often referred to as operational net cash flow or cash burn rate which is something very important to know. Let me explain more.

Cash burn rate is a rate of change so it is important to define the period of time, as it is for any rate. So if we can estimate that our cash burn rate per month is $50K (i.e., $50K/month) and I know I have $500K of cash in bank (unencumbered of net liabilities), then I can estimate I have enough cash to last me approximately 10 months. That is very important information to know – and you should know it for sure.

But again, this number has it strengths and weaknesses. The reality is that while it is technically true, when you have employees and other obligations, and you start to run down to less than 3 months (for a general rule) of cash left relative to burn rate, you are flying awfully close to the sun and strange things start to happen. Strange things like employees freaking out and the good ones leaving. However, at the beginning it is very common to fly very close to the sun and everyone just doesn’t get paid but as you get bigger, it is not as well accepted.

That is the simplest explanation of new venture finances but now let’s dive a little deeper on all of these.

Cash In

Cash in is made up of two major components – one-time transactions and recurring. Let’s take a look at each of these and define them for you.

One-time transactions

• Net proceeds from a fundraising effort: If you raise money in a period from selling stock in the company (called “equity”) or even if you get money from taking out a loan, that is cash into the company but it is not from operations and it is not something that should be expected for the next time period.
• Sale of an asset: Similarly, you might sell off an asset that either you don’t need or because you have a keen need for cash. That could even be something like computers that you then leaseback. For whatever reason, this inflow of cash likewise cannot be expected to happen in the next time period so it should be called out as one time.
• Legal settlements: You might get paid for a legal settlement that someone wanted to settle with you to avoid further litigation or gain access to your Intellectual Property. Again, this is a one-time payment and should be called out as such.
• One-time payments not expected to recur: There could be others ones that we have not listed above but at this point, you should recognized the nature; they are one time and cannot be expected to happen on a predictable basis.

Recurring

• Sales to Customers (OTC or Subscription or Licensing/Royalty): What is something that you can expect and forecast, is revenue from customers who buy your product. The best type of revenue (which is the same as “sales”) is subscription revenue because it is highly predictable and, hopefully, contractually obligated. Purchase of products that is a one-time upfront charge are also predictable because we can forecast sale unit and price volumes for a time period. While something that we can forecast with confidence, they are less assured than subscription revenue. Licensing/Royalty revenue is like subscription revenue for the most part but it is a mix that depends on how much our partner sells. This (Sales to Customers) is for the most part, the more interesting cash in to a business. It is the starting point for determining the all important “cash flow from operations” calculation.

Cash Out

This section is very similar in structure to cash in so let’s look at the underlying components of the two big components.

One time transactions

• Buying capital assets: A big use of cash for many businesses, especially those with a hardware component in their product, is the acquisition of big equipment/computers. Even software and data businesses need strong computer platforms to make the businesses run. Many companies, to preserve their cash, will lease this equipment which can make sense. However, if you have access to cash, it is easy to do the calculations and see that you can save a lot of money in the long term if you buy rather than lease. The leasing companies are making money in financing, which may be a premium you are willing to pay because it is the cheapest way to getting capital. It is damn hard, expensive and time consuming to get capital when you are a startup so leasing may be a good option to offset this use of cash but you are going to pay for it. No free or even cheap money anywhere.
  Note: When you buy a “capital” asset, it means it is big enough to “depreciate”.  Depreciation means that because you are going to use that asset (e.g., a computer, a manufacturing machine, etc.) over many years, you can spread the expense over the number of years it has a useful life. That useful life is not something you determine but it is predetermined by accounting standards. It is usually 3 or 5 years. The “expense” however is a non-cash measurement that accounting uses to show the estimated profitability of your organization in a certain time period (e.g., a year, a quarter, etc.).  This makes sense so people can understand pro-rated profitability of your business but it does not explain the cash flow situation – and as any entrepreneur know, CASH IS KING! The same thing can be done for software development or other investments that are expected to pay off over many years and for them, the term “amortization” rather than depreciation is used. This is one of the biggest differences between a “Profit and Loss Statement” and the operating cash flow view that an entrepreneur has to be hyperfocused on.
• Finder’s Fee/Signing bonus (not expected to repeat): The rest of this list is simply one time fees that can change significantly or disappear from one time period to the next. One common example is that you have to pay a one time finder’s fee to get a key position filled and/or a one time signing bonus. You do not expect this to be a recurring use of cash.
• Legal settlements: More often with legal settlements in my experience, they are “cash out” rather than “cash in” where you pay a settlement fee to make a situation go away so you can focus on your business. This might be the purchase of a trademark or some other Intellectual Property.
• Severance: This is really just a legal settlement and the reverse of the signing bonus, but it requires a one time cash payment.
• One time programs/initiatives not to be repeated:  By now you should see the pattern and this could be a big campaign, tradeshow launch or something that you are confident will not be recurring.  Becareful that before you put things into this category, they are not things that actually will recur each year – like a yearly marketing campaign or tradeshow.  Website rebuilds are another tricky example. It is likely that you will need to make continual investments in websites and digital marketing campaigns so don’t put them in this bucket too easily.

Recurring

These are the items that require a lot of attention and are difficult but very important to get a good estimate on. Even more important, is to develop a model that makes clear what is driving the cashing going out of the business (“expenses” is an approximation here but not exactly the same); what are the key items and assumptions?

• Cost of Goods Sold (BOM plus direct labor): This is actually pretty straight forward. It is all of the items listed on the BOM (Bill of Material) which can be priced out easily by calling a few vendors. The BOM is a list of all the items required to produce your product. Sometimes people interpret “items” as being parts and do not include the incremental or “direct” labor required to build one more of the product. The direct labor costs should be estimated and absolutely be included too. Your Cost of Goods Sold (often shorten to “COGS”) will likely go down as volume goes up so when you give a COGS estimate, you should tie it back to a volume estimate. In the reporting of past finances, the COGS is known and determined so no estimate is needed. Obviously COGS is affected by the pricing of the components and the companies ability to negotiate good deals for itself with vendors.
  Note: “Gross margin” is a term that is often used. This is the amount of money the company makes from the sale of its products before non-product (i.e., Marketing and Sales, Research and Development, General and Administration) expenses are taken out.  So if a company sells 100 products at $1,000 each netted to the company (a total revenue of $100,000) and the COGS for each product is $333 (total COGS of $33,300), then the Gross Margin is $66,700 for that period of time. The Gross Margin Percentage is 66.7%. You can think of this as the Product Profit Margin.
• Marketing and Sales (M&S): This is all the cash required to create the demand (i.e., marketing) and then fulfill the demand by getting customer to buy the product (i.e., sales).  All the many elements of this, marketing people, campaigns, consultants, systems, collateral, etc, will be spelling out in the model later and similarly for the sales function.
• Research and Development (R&D): This is all the expenses associated with the development, acquisition and refinement of the “technologies” (used in the broadest definition possible) needed and possibly needed for our product and its evolution. That is the research component. The development component is all the expenses to develop the product that marketing and sales will sell. Again, all the various components of this like people, computers, systems, training, research materials, etc. will all be detailed in the model later.
• General and Administration (G&A): These are all the expenses needed to run the business that are not in the M&S or R&D buckets to make a viable business. This includes legal, financial, rent, utilities, insurance, payroll, office equipment and supplies, board of directors, top leadership, etc.
  Note: In each of these salaries, you should consider how much of your expense is related to salary and benefits for employees, which does not mean consultants. The employee salary line is so important to know because it is not an expense that you can cut back in quickly or easily, despite what you might think. Hiring should be a significant vetting process as you will be taking on a commitment to someone. Don’t do it too quickly or take it lightly. Getting rid of employees is a time consuming and costly process that has significant ripple effects if not done properly. This is not always understood by first time entrepreneurs (including myself at the time) and it is why I call this out. Just ask any experienced entrepreneur.

Assets That Cause Your Bank Statement to Be Understated

The cash in and cash out over a period of time, gives us a very important sense of the needs of the business, we also need to know our position at any time. The bank statement gives us a picture of the finances at a specific time whereas the cash flow over a period of time gives us a video picture of how this are trending. The technical words from systems analysis is that a bank statement is a stock (analogy, the level in the bathtub at any time) and the cash flows give us the flow (or the rate at which water is going out the drain combined with the rate water is coming in via the faucet).

That being said, just looking at the bank statement can give you an imperfect impression of your financial snapshot position at the time it is issued.

There are other things that you should also consider.

The biggest asset by far that valuable to you is money you are owed. This is call “Accounts Receivables” or “Accounts Receivables Outstanding” and it represents the amount of money you are owed at that time. Often another measurement is the “averaged days sales outstanding” of your receivables, which indicates how long these receivables have been due to you. A good company collects their receivables promptly but the terms you may offer your customer could be 30 days upon receipt of the invoice. That gives the customer a grace period of 30 days to pay which a smart customer will take. You will pay a price by not having this cash immediately and that is call “float,” the amount of time the customer has money due to you.

It is certainly in your benefit to collect the money as soon as possible because you have already paid your suppliers most likely and you are having to subsidize this float, likely with money that is very difficult, costly and time consuming to get.

Still, understand Accounts Receivables is an asset that is not included in your bank statement and it means your bank statement cash position is understated by that amount or some percentage of it that you are very confident you will be able to collect.

Liabilities That Cause Your Bank Statement to Be Overstated

Like with Accounts Receivable that cause your bank statement to understate your current cash position, there are liability that mean your bank statement cash position is overstated.

The first and probably biggest of these is the money you owe to others including suppliers  and employees in salary which is called “Accounts Payables” or “Accounts Payables Outstanding” at the time. This is a liability that you will have to pay off. Likewise to Accounts Receivables but now you are on the others side, if you pay these later, that give you the cash longer and you get the float.

Another liability that you should be aware of an track is customer that might default and never pay, which would result in bad debt. These means that your Accounts Receivables should be cleaned up to not include customer that will never pay you.

The amount of time you pay your vendors and the amount of time your receive cash from your customer is usually material so you have needs to float this cash for a period of time. For instance, you may have to pay your vendors within 15 days for the parts to build your product. You may well have to buy the parts on average 90 days before they are finally assembled and set out to a paying customer.  That means you will have to pay for the materials in a product, on average 75 days before it ships to a paying customer. That customer then has 30 days to pay for the product.  Assuming they pay right on time at 30 days, that is 105 days between when you had to carry the expenses of the COGS to when you actually got paid. That time requires cash to hold you over. That cash requirement is called “working capital”.  It might not seem like a lot but any cash is important for a new venture. It also turns out to be a requirement for a lot of cash when you volumes go up as your business scales. The irony being, the more you succeed, the more you need cash. A nice problem to have but a problem nonetheless.

Accounting

The above explains the fundamentals of a business that you really need to know to operate it. There are others however who will want to understand the financial strength or weakness of your business (e.g., banks, investors, partners, acquirers) and they would like standard formats with agreed upon standards that can be certified by people they trust.

These standards are define by a field called accounting. They provide a rigorous standardize outline of a business’s financial health. They are financial dashboard for your new venture. They specifically indicate where your money is going, where it’s coming from, and how much you’ve got to work with. It gives you all the information to operate your business in a comprehensive manner but it just is more difficult to get than the manner in which was explained earlier in this chapter. It is, however, the standardize way to do it and it is what people expect to see from your top financial officer.

The three common statements are the Income Statement (also called the Profit and Loss Statement), the Balance Sheet and that Statement of Cash Flows. Let’s have a quick, high level look at what each is.

Income Statement

This statement show you how “profitable” was over a specified time, such as a month, quarter, or year. It gives you an indication of what the cash might be but it is different first of all because of non-cash expenses. When a big asset or expense is made the can be depreciated or amortized, it will only show the amount of expense it allocates to that time period not the amount of cash that went out the door for that asset. This can either overstate your profitability relative to cash flow (if you paid for the asset in that time period) or understate your cash flow relative to profitability if you did not buy that assets in the designated time period. A very important second area that creates a difference between profitability and cash flow is the recognition of revenue. Specifically, a customer may agree to purchase your product and it may be install and the customer formally accepts it. At that point the revenue can be recognized and accounted for in your Income Statement. The customer however may not have to pay, as we discussed above, for 30 days as per your agreement and, in fact, they may not pay for 60 days. The difference would be that your profitability would be higher than your cash flow, until the customer pays and the cash is received in your account.  Likewise, you may have to pay for something in your product (like COGS) and not recognized the expenses at the same time the cash has to go out of your company which can be another cause for discrepancy between profitability and cash flow. You must understand this limitations of the Income Statement but also understand that is still is one valuable indicator of the financial health or your business. All of these financial statements have strengths and weaknesses and they are used together as a suite to give a multidimensional view that is valuable.

Net Profit is the Gross Margin minus the M&S, R&D and G&A expenses which is very important to know as well but is much different than the Gross Profit which is another name for Gross Margin so be careful with your terms like Profit. Be specific and ask questions if you are confused.

Balance Sheet

An Income Statement is a view of the venture’s finances over a period of time while the Balance Sheet is a snapshot of the financial position at one given time. It tells you within the strict rules of accounting, what assets you have and what liabilities you owe to others. Inherent in this is to point out how much the company is worth, which is called “Shareholder Equity”. Shareholder Equity = Value of Assets – Value of Liabilities.

That may sound simple but it gets more complicated very quickly.

Assets can be broken down into short term assets, like cash and assets that can be quickly translated into cash, like Accounts Receivables as we talked about already. So it deals with that adjustment that should be made when trying to translating the bank statement into your real short term cash position. Short term is generally consider something that could be converted into cash within a year easily which may include inventory but that is also something that would be discounted a lot more than cash. Short term assets are also often called current assets.

In addition to short term assets, there are long term assets which are things like inventory (could be in either depending on nature and context), computers, other equipment, furniture, land, buildings, notes receivable that are not short term, and even intangible property such as patents and goodwill. As you can imagine, as you get into things like patents this gets less precise and when you move into the area of “goodwill,” even with strict account rules, it can get pretty abstract.  Long term assets are also called fixed assets.

Banks and most experience entrepreneurs significantly discount longer term assets, especially ones that are not hard assets that have a significant remaining useful life.

Liabilities are very similar to what we discuss in the section previously in this chapter title “Liabilities That Cause Your Bank Statement to Be Overstated.” At the risk of repeating, let say there are short term liabilities and longer term liabilities very similar to the Assets. These would be Accounts Payables but also potentially interest payments due on loans or mortgages. It could also be expenses you have accrued, meaning owe but not yet been invoiced for or accounted elsewhere, such as utilities, taxes, or wages owed to employees.  Similar to Assets, short term liabilities are often called current liabilities and long term are called non-current (as opposed to “fixed”). Long term liabilities is the principal on a loan that is outside of 12 months. The interest would be in short term liabilities. The dividing line for these groups of liabilities is likewise one year as you probably deduced from the preceding example.

Equity is a trickier concept because it shows some history in it that might surprise you. The will be an indication of the value of the company (not the “market value” but the “book value”). The book value is the equation above is a result of how much money was put into the company to begin with, how much has since been put into the business by investors who bought stock (or equity), how much money has it made and how much has been taken out of the business. These things will determine the book value. The market value is a completely different calculation for another time depending on factors such as growth rate, gross margins, capital efficiency, intellectual property, investor interest in the field, competitive strength and many other tangibles and intangibles. That is for later in the program when we discuss valuations for companies.

The first thing people look at in a balance sheet is the short term assets (essentially the cash and cash equivalents) and then subtract the short term liabilities. This gives the reader a sense of how much cash or “dry powder” does the company have.

The next question they are trying to figure out is the “burn rate” then. This is how much cash the company is losing each month (assuming it is losing cash). They then take the amount of money the company has and divide it by the burn rate to figure out how long the company has to go on the cash it has today without raising more money.

For example if from the balance sheet, it appears the company has $1 million dollars and it monthly burn rate is $100k per month, we know it has an estimate 10 months until it runs out of money without a further injection of cash. If the same company has a burn rate of $10K per month, it has a runway of 100 months, which all thing considered, is a lot better.

Statement of Cash Flows

The Cash Flow Statement sounds like exactly what we want but it can be complicated and is meant to integrate with the Income Statement and Balance Sheet so can, in my humble opinion, can more confusing than the simple explanations (I hope) I gave you above. There are also very strict rules about how to define parts of it.

Fundamentally, the Statement of Cash Flows tells you how much cash entered and left your business over a particular time period.

This statement has three parts:

1. Cash Flows from Operations: This is what you make and spend in the normal course of doing business, which comes from your Income Statement.
2. Cash Flow from Investing Activities: This is money you invest in capital assets as we discussed in the Income Statement section, by purchasing new equipment or investing in major projects that can be amortized for your business.
3. Cash Flow from Financing Activities: As this title says, this is money that comes in or goes out of your company not related to the operations of the business but because of investors putting money in, getting money from loans, debtors getting money out or owners paying dividends. It also might be from one-time activities that don’t fit into the first two buckets but add or subtract money from the company.

Tip: Get your customers to pay you upfront for your product and it will give you a big advantage on cash flow. Instead of working capital being a drain on your cash, it will be a positive contributor to cash. This is another reason why a subscription business is attractive.

Summary

This is a very simple view of finances and there are thousands of books and courses on this topic and each sentence above, but now you should know enough to see the full landscape and not be daunted by this topic. At the end of the day, it is very simple math clothed in contextual complexities and definitions but it comes down to, do you have enough cash to run your business and grow it? How much and when?

Key points of chapter 2:

• Cash is what matters and that is not clear from standard accounting statements and you should generally know the difference.  That difference is cash flow for assets that are depreciable and working capital – the difference of when you have to pay and when you receive payments not when the expenses and revenue is recorded from an accounting standpoint.

• Revenue and expenses come in two varieties: one-time and recurring. All things being equal, recurring is much preferred for revenue whereas one time is preferred for expenses.
• As a startup, always know your cash balance in the bank and your monthly burn rate so you know how many months of runway you have. Don’t let that runway get too short otherwise bad things can start to happen that will cause it to decrease even faster.

It’s the start of a new year, so what could be better than kicking it off with the first chapter of the upcoming book on financial literacy for founders? The only thing better than it would definitely be to get your thoughts on this new material, have you comment with thoughts and suggestions, and further share this material with others who might benefit from it, even in draft form.

Chapter One

Professor Josh Lerner of Harvard Business School is one of the most recognized and respected entrepreneurial finance professors of our generation. In 1994, I had the honor of taking his class and while I learned a lot in the course, the most important gem was in the first class in the first few minutes. “A financing strategy supports a business strategy; it is not the business strategy.”

Being an entrepreneur and working with thousands of entrepreneurs, I found myself continually coming back to this fundamental principle to ground discussions on strategy and execution. It seems obvious but in the heat of the battle, entrepreneurs (including myself) can get confused and think the goal is to raise money. It is not. It is simply an optional means to an end.

The goal is to build a new venture that serves a purpose (i.e., “raison d’etre”) and is economically sustainable. Success, if measured by how the business is able to have as much positive impact, aligned with the aforementioned purpose, as possible. The purpose is rarely singular and it is almost always multidimensional with multiple stakeholders.

While some people and media tend to get obsessed by it, the amount of money the company raised or the brand of the investors they raised it from is not the objective of a new venture nor a true measure of success. These factors are but supporting tactics that may, or may not, increase the odds of success of your business strategy and execution.

A company has never been successful because of a great fundraising strategy alone. On the other hand, I have seen many companies destroyed by poor fundraising strategy and execution.

When put in the proper context, a good fundraising strategy and execution could increase the odds of success and even, in rare instances when coupled with excellent business strategy and execution can become a significant competitive advantage.

So what is my point? Focus first on developing a great business and keep the fundraising in perspective. It is NOT the main thing. Ironically, the best way I have found to raise money is to focus on building a great business.

But wait, then why are we spending time on a “Financial Literacy and Investor Readiness Program”?

Let me explain. The number one job of a CEO in a startup company is to not run out of cash (attribution to my former teaching colleague, Howard Anderson). Think about that carefully, because it is why this book was written. A body that does not have oxygen will die. That is why on a plane they tell you first to put on your own oxygen mask before you start to help others. Likewise, for a business, cash is oxygen. Without it, the business dies and there is no purpose served, no strategy, no customers, no products, no employees, etc.

As such, the most fundamental scoreboard a business had to watch is the financial one. It might not be the most exciting but without it, you have nothing. In this program, we will not be turning you into a finance expert or teaching you tricks that will make your business successful. We will just teach you how not to lose in this area so that you can win with your core business strategy and execution. The parts where you can really distinguish yourself are innovation, creating a unique value proposition, culture, and team.

Because money is the oxygen for the company and financials are the oxygen monitor to keep it alive, everyone in the company should have basic financial literacy to understand key metrics. It should not just fall to the CEO and CFO. Everyone is invested in the venture surviving because if it does not, everyone is dramatically affected.

Key points of Chapter 1

• The financing strategy and execution support the business strategy and execution, it is NOT the business strategy and execution.
• The #1 job of the CEO in a new venture is to not run out of cash.
• Financials are an essential scoreboard for your business that everyone should understand.

We will teach you in this book:

1. Financial Literacy: What you need to know about finance to run your business
2. Financial Modeling: How to develop a financial model to generate projections of your business that provides insights, meaningful projections, a potential path to greatness, and a planning tool
3. Milestone Financing: The reason for milestone financing and what exactly it is.
4. Sources of Financing: We will discuss what are the various sources of capital for a business and what are the pros and cons of each.
5. Sourcing: How to generate leads, filter the leads to make a target list, and then how to sequence this list.
6. Investor Presentations: How to develop and customize an investor presentation.
7. Understanding Legal Dimension: We will provide a high-level overview of typical terms and conditions of financing and other legal considerations.
8. Setting Up the Meeting: How to get the meetings you want
9. Negotiation:  How to approach the funding process and negotiate with potential funders
10. Current Considerations:  We will also talk about what are the current considerations in fundraising.
11. Presenting: We will practice presenting to investors