Month: January 2017

Valuing a Start Up

Conjuring Wealth out of Thin Air

 

In order to raise money for a venture, you must first come up with a valuation for the nascent enterprise.

Valuing a start up can seem like an act of legerdemain, a magic trick. How do you put a concrete value on something that only exists as an idea, vision, or, at best, a partially formulated enterprise?

There are two interconnected valuations:

  • The Valuation of the enterprise based on financial projections
  • The pre-money Valuation for the current round of funding

 

The link between the two is what shows potential investors that if they put money in at the current proposed funding valuation, that they stand to make a significant return, if and when the company reaches a valuation based on the financial projections.

 

Future Tense

 

Estimating the present value of future cash flows is the game. The first valuation is based on creating scenarios around your financial projections and estimating a realistic discount rate to pull those numbers back to present value.

 

This valuation technique has lots of numbers populating a spreadsheet and math is involved, which gives it an air of authority, validity and accuracy. But all those numbers in the spreadsheet are forecasts based on assumptions and predictions that, at the end of the day, were pulled out of thin air.

 

Those numbers are usually overly optimistic both in their size and the timing of when they will come in as revenues. Any experienced investor will look for these numbers to be credible as an indication of whether or not the founders are reliable business people.

 

The source of this overstatement error, and a red flag for investors, is reflected in in the fact that, being so close to the project and emotionally invested in its success, the revenue projections created by the founders are too high and the expenses too low.

 

Don’t fall prey to your enthusiasm and hype and keep a little emotional distance when working on financial projections and the related budgets.

 

“Hockey Stick” projections

 

It used to be that radical prediction of growth in revenues was a dead giveaway of an inexperienced and overly optimistic founder. But now with Growth Hacking marketing techniques, a revenue graph that looks like a “hockey stick” can generate excitement among investors; with the caveat that the strategy is reasonable in support of this kind of growth.

 

Discount Rate

 

The discount rate is the other important factor. Calculate, refine and adjust your discount rate based on comparable public companies and their rate of return, or other risk-adjusted returns investors require in the market for a similar enterprise.

 

We look at public companies because they are the ones that we have access to their financials. Go to the EDGAR section of the Securities and Exchange Commission website www.sec.gov and look at the 10K filings. You need to identify comparable companies as part of your industry and competitive analysis as well as for valuation, so the SEC site is a great resource.

 

Crystal Ball

 

The nature of your forecasts is to get an idea of the future. Unless you have a powerful crystal ball, this is best expressed as a range of values. Your financial projections are essentially Income Statements projected into the future. They should show an EBITDA and free cash flow that support a significant present value range of the future cash flows.

 

Optimism and Pessimism

 

Determine the range of cash flows by creating scenarios on either side of your expected projections: an optimistic scenario and a pessimistic scenario. These scenarios will show you what kind of room and resources you will have to weather events when things don’t go exactly as planned.

 

You want to make sure that even if things don’t go as predicted that there is enough of a cushion to survive. Compare the present value range to the valuation you are asking for the current round of funding (the second valuation mentioned above).

 

The pre-money Valuation

 

This valuation is market driven and negotiated based on the interest of potential investors and their appetite for your particular set of risks. This funding valuation needs to be supported by a feasible scenario (the first valuation) where the investors stand to make a significant multiple of their investment.

 

For example if you ask for a round at a $10M valuation (that is $2 per share for 5 million shares say), and the present value of the projections is in the $1B range then you can show that this venture has the potential to be a 100X investment, or two orders of magnitude. That is the kind of potential investors like to see. If the investment has that kind of credible potential then even if it falls significantly short, there is still the potential for a sizable return. That type of scenario mitigates perceived risk in an investor’s mind.

 

That could be appealing and attractive to some investors with an appetite for the particular technical and market risks of your enterprise and their belief that your growth projections are credible. This is the psychological crux of the deal and where greed needs to override fear to complete a transaction.

 

How much for how much

 

This is the valuation that is used to calculate how much of the company you are willing to part with in exchange for the funding. For example if you are proposing a funding round at a $5 million valuation and you intend to raise one million dollars then you are proposing that the investor will get 20% ownership of the company.

 

Summary

 

If any of this is confusing, let me summarize and restate this approach to try and clarify the points. There are two valuation numbers associated with raising capital:

 

  • The valuation based on discounting the cash flows from your financial projections over a range of scenarios. This is a clear-cut present value calculation based on the time value of money. The numbers being discounted to present value, however, are numbers that you invented and their credibility is crucial.

 

  • The value of the enterprise based on how much a potential investor is willing to pay for a share of the company as it stands today. This valuation is a market driven negotiation with potential investors and takes into account the perceived uncertainties surrounding achieving the cash flows you are projecting.

 

The pre-money valuation of the company (the value before investors put in their capital) should be some fraction of the valuation based on the present value of the future cash flows so the investors see they stand to make some multiple of their initial investment.

 

There is art and nuance involved in coming up with a suitable valuation. Think about how much money you need in order to get to revenues and a sustainable business model, and how much of the company you are willing to part with in order to get those funds. This is the fundamental trade-off.

 

A sensible strategy is to first get a range of valuations for the present value of the projections and then divide the average by 10 or 50 or 100 and make that the asking valuation for investment. This denominator will depend on what round of funding you are in and what milestones you have already achieved. The closer to sales, the lower the multiple; it is all about risk and reward. Whether there are investors that will have an appetite and what the demand will be is another question.

Use this approach to calculate and converge on the funding “ask” supported by the PV of future cash flow valuation. This process is transparent and can create a great deal for your company and your investors. This is the magic of creating something out of thin air, an idea, and putting a dollar figure on it.

 

Let me know what you think and if this is in any way helpful. Thanks!

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The Big Picture of Financial Statements

 

The three Financial Statements: Balance Sheet, Income Statement, and Cash Flow Statement, are interconnected and the accounting numbers flow through them.   They are the measure of a company’s performance and health.

The basic interconnection starts with a Balance Sheet showing the financial position at the beginning of the period (usually a year); next you have the Income Statement that shows the operations during the year period, and then a balance Sheet at the end of the year.

The Cash Flow is necessary to reconcile the cash position starting from the Net Income number at the bottom of the Income Statement. The cash number calculated from the Cash Flow Statement is added to the cash reported on the beginning Balance Sheet. This number needs to match the actual cash in the bank at the end of the period and is used as the Cash account balance at the top right (Asset column) of the end of year (EOY) Balance Sheet.

The Net Income number from the Income Statement is then added to the Retained Earnings number in the Equity section (lower left hand side) of the end of year (EOY) Balance Sheet.

Changes in non-cash accounts like Accounts Receivable and Accounts Payable and Depreciation and Amortization will make up the difference between the Cash Flow number added on the right side of the Balance Sheet and the Net Income number added on the left hand side.

When this is done correctly, all the numbers should reconcile and the Assets will be equal to the Liabilities and Equity (remember the Accounting Equation A = L + E) of the EOY Balance Sheet.

Financial Statement Interconnections and Flow

Think of it as a system of two Balance Sheets acting as bookends for the Income Statement. And the Cash Flow Statement used to reconcile the Net Income (or Loss) at the bottom of the Income Statement with the amount of cash actually in the bank. This process accounts for every penny that has come in, gone through, and gone out of a company during the period.

Understanding these three financial statements and how they knit together will allow you to assess the financial health, viability and prospects of any company, and help you make rational fact-based investment decisions. This is how Warren Buffett does it.

This post ties together the functionality of the financial statements. I hope this might be an “aha” moment for you. It was for me when I finally realized how this all fit and worked together. This is the basis of Financial Literacy and Capitalism. Understanding this conceptual big picture of accounting will provide a context to keep you from ever getting lost in the details.

 Financial Flow States: The Cash Flow Statement

 

Besides the Income Statement and the Balance Sheet, there is a third financial statement called the Cash Flow Statement. The Cash Flow Statement reconciles the Income Statement with the actual cash position of the company (the balance in the bank account) by adding and subtracting revenues and expenses that were properly recorded on the Income Statement, but are non-cash events.

By non-cash events I mean expenses that have been properly associated with transactions or obligations but where no cash has yet changed hands. Depreciation, Amortization, and changes in Accounts Receivable and Accounts Payable are examples of non-cash events.

These additions and subtractions are reported in the Operations section of the Cash Flow Statement since they are related to the operations of the company that are reported on the Income Statement.

 

The need for a Cash Flow Statement arises from Accrual Accounting where we book items like Receivables and Payables and Depreciation in order to provide a more accurate picture of the operations of a company by matching revenues and expenses. These “non-cash” transactions distort the Income Statement relative to how much cash actually came in and went out of the company and how much is actually in the bank. The Operations portion of the Cash Flow Statement reconciles these differences.

Besides Operations, there are two other parts of the Cash Flow Statement that follow the Operations portion: Investing and Financing. The Investing section shows the money that was spent on capital equipment items that don’t show up as expenses on the Income Statement because they have been capitalized as Assets. It also shows any money that came into the company from the sale of assets.

The Financing section shows money that has come into the company through the sale of stock or the proceeds of a loan. It also shows any money that went out of the company from stock repurchases or loan repayments.

This reconciled cash balance is the number that then is added the previous Cash account balance reported at the top of the asset column on the Balance Sheet. This is important. This is how the financial statements are interconnected and reconciled.

 

The Cash Flow Statement is not as intuitive as the Balance Sheet and Income Statement. It will take you some time to wrap your head around it. Don’t run screaming if this concept isn’t crystal clear yet; just understand that the Cash Flow Statement is the connective tissue between the Balance Sheet and Income Statement.

The concepts behind the Cash Flow Statement are relatively nuanced and may seem a bit confusing to someone familiarizing themselves with the basic principles of accounting for the first time. As you read and work with financial statements, the different aspects of the Cash Flow Statement will become clear.

Sample Cash Flow Statement

Below is an example of a simple Cash Flow Statement. Since they vary in their contents and presentation it is a good idea to take a quick look at a bunch of examples. Google the term “Cash Flow Statement” and you will see lots of examples in various formats and presentations.

 

Sample Corporation

Statement of Cash Flows

For the Year Ended

December 31, 2015

(In Millions of Dollars)

 

Operating Activities

Net Income from Operations                                                  $10,000

Add: Depreciation Expense                                                           100

Total Operating Activities                                                       $10,100

 

Investing Activities

Purchase of Equipment                                                           $ (1,000)

Sale of Equipment                                                                          500

Total Investing Activities                                                          $ ( 500)

 

Financing Activities

Increase in Long Term Debt                                                   $2,500

Issuance of Stock                                                                    5,000

Dividends Paid                                                                        (3,000)

Total Financing Activities                                                        $4,500

 

Net Change in Cash Flow                                                   $14,100

 

Understanding Financial Statements: The Income Statement

There are two basic financial statements: the Balance Sheet and the Income Statement.

The daily operations of a business are measured in the money that comes in as revenues, the money that goes out as expenses, the money that is retained as profit, the money that is invested in operational assets, and the money that is owed. It’s all about the money. Financial statements follow the money.

 

The report that measures these daily operations, of money in and money out over a period of time, is the Income Statement.

Revenues minus Expenses equals Net Income

The Income Statement can be summarized as: Revenues less Expenses equals Net Income. The term Net Income simply means Income (Revenues) net (less) of Expenses. Net Income is also called Profit or Earnings. The terms “profits,” “earnings” and “net income” all mean the same thing and are used interchangeably. They are synonyms for the bottom line number on the Income Statement. Revenues are often called Sales and are represented on the top line.

You understand the dynamics of this concept intuitively. We always strive to sell things for more than they cost us to make or buy. When you buy a house you hope that it will appreciate in value so you can sell it in the future for more than you paid for it. It’s also the rule for stocks: buy low, sell high. In order to have a sustainable business model in the long run, the same logic applies. You can’t sell things for less than they cost to make and stay in business for long. If you own run a sandwich shop you had better make sure that you are selling the sandwiches for more than they cost you to make.

Think of the Income Statement in relation to your monthly personal finances. You have your monthly revenues: in most cases the salary from your job. You apply that monthly income to your monthly expenses: rent or mortgage, car loan, food, gas, utilities, clothes, phone, entertainment, etc.  Our goal is to have our expenses be less than our income.

There is an old adage: “If you outflow is more than your income, your upkeep is your downfall.”

Over time, and with experience, we become better managers of our personal finances and begin to realize that we shouldn’t spend more that we make. We strive to have some money left over at the end of the month that we can set aside and save. In business, what is set aside and saved is called Retained Earnings.

Some of what we set aside we may invest with an eye toward future benefits. We may invest in stocks and bonds or mutual funds, or we may invest in education to expand our future earning and career prospects. This is the same type of money management discipline that is applied in business. It’s just a matter of scale. In business we buy assets that help the enterprise expand or perform more efficiently. There are a few additional zeros after the numbers on a large company’s Income Statement but the idea is the same.

This concept applies to all businesses.   Revenues are usually from Sales of products or services. Expenses are what you spend to support those sales in terms of the operations: Salaries, raw materials, manufacturing processes and equipment, offices and factories, consultants, lawyers, advertising, shipping, utilities etc.   What is left over is the Net Income or Profit.   Again: Revenues – Expenses = Net Income.

Net income is either saved in order to smooth out future operations and deal with unforeseen events (save for a rainy day); or invested in new facilities, equipment, and technology. Or part of the profits can be paid out to the company owners, called shareholders or stockholders, as a dividend.

The Income Statement is also known as the “profit and loss statement”. Business people sometimes use the shorthand term “P&L,” which stands for profit and loss statement. A manager is said to have “P&L responsibilities” if they run an autonomous division where they make the decisions about marketing, sales, staffing, products, expenses, and strategy. P & L responsibility is one of the most important responsibilities of any executive position and involves monitoring the net income after expenses for a department or entire organization, with direct influence on how company resources are allocated and responsibility for performance.

Google the term “income statement” and you will see lots of examples of formats and presentations. You will see there is variety depending on the industry and nature of the business but they all follow the basic principles outlined in this post.

Remember: Income (revenue or sales) – Expenses = Net Income or profit

If you are interested in a deeper dive on these concepts check out my books Learn Accounting Fast! and Reading and Understanding Financial Statements.

What does the Balance Sheet balance?

 

The balance sheet is structured to show the amount and type of assets an enterprise owns and how those assets are funded. One side of the balance sheet shows what you have (assets) and the other side shows how you paid for it (debt and equity).

Assets can be purchased and paid for in two ways: with debt or with equity (or a combination of the two). What a company owes, the debts or loans, are called Liabilities; what a company owns is the Equity or Stock.

The Liabilities and Equity are equal to the Assets. They are two sides of the same coin and they must balance; hence the term Balance Sheet. This is a fundamental principal of Accounting called the Accounting Equation. Assets = Liabilities + Equity.

Balance Sheet Format

A Balance Sheet is typically organized in two columns with the Assets on the left and the Liabilities and Equity on the right. It is divided into subcategories with the most current types on top and the more long-term varieties towards the bottom.

Current Assets are ones like cash that can be used on short notice and Long term Assets are things like factories that would take longer to convert to cash. Current means short term; stuff that needs to be addressed within one year. Long-term means stuff longer than the next year.

Bills that need to be paid within the month are considered Current Liabilities and loans that are paid back over years are considered Long term Liabilities.

Equity is what the owners actually own. Equity is basically Assets less the Liabilities and is shown as accounts below the Liabilities on the left hand side. Equity is shown below the Liabilities because debt has senior claims on the assets. In the event of liquidation like a bankruptcy, the debt holders get paid from the sale of assets first and then anything left over goes to the equity holders.

Here is an example Balance Sheet to get and idea of the format; notice that the Total Assets equals the Total Liabilities plus Equity. For more info check out my book Reading and Understanding Financial Statements.

Balance Sheet Basics

 

The Balance Sheet is a condensed statement that shows the financial position of an entity on a specified date, usually the last day of an accounting period. This is a follow up to the post on Financial Statements.

Among other items of information, a balance sheet states

• What Assets the entity owns,
• How it paid for them,
• What it owes (its Liabilities), and
• What is the amount left after satisfying the liabilities (its Equity)

Balance sheet data is based on what is known as the Accounting Equation: Assets = Liabilities + Owners’ Equity.

Think of a Balance Sheet in terms related to everyday life. Home ownership, when you have a mortgage, is represented as a Balance sheet. Your home ownership basically has the three components of Asset, Liability and Equity. The Asset is the value of the house. This is determined by an appraisal. An appraisal takes into account recent sales of homes in the area and compensates for differences like the number of bath or bedrooms, the size of the lot, etc.

The Liability is the mortgage. This is how much you owe against the house. The Equity is the difference between the value of the Asset and the amount of the Liability. If your home is worth $200,000 and you have a remaining mortgage balance of $150,000, then you have $50,000 in Equity. We sometimes call this homeowner’s equity.

If your mortgage balance is more than the value of the home, then you are considered “upside down” or “under water”. The same principle applies to a business: if the value of its Liabilities is more than the value of the Assets then the enterprise is insolvent and probably headed for bankruptcy.

A Balance Sheet is organized under subheadings such as current assets, fixed assets, current liabilities, Long-term Liabilities, and Equity With income statement and cash flow statement, it comprises the financial statements; a set of documents indispensable in running a business.

Understanding Financial Statements

understanding-financial-statements

Understanding Financial Statements Part 1

This series of posts will give you an understanding of Financial Statements ASAP. This knowledge can be highly impactful for the quality of your career, job prospects, and life.

Everyone should have a basic understanding of Financial Statements: what they are and what information they provide. It’s a competency that can open up opportunities and vistas that are closed off otherwise. Financial Statements are the basic language of money and business.

Executives routinely share and discuss financial data with marketing, operations, and other direct reports and personnel. But how much do you really understand about finance and the numbers? A recent investigation into this question concluded even most managers don’t understand enough to be useful. Check out this quick test to see how you stack up.

Three Main Financial Statements

There are three main financial statements and they are linked together to provide a picture of the financial position and health of an enterprise. They are the end product of accounting meaning they are the reports generated by accounting covering all of the transactions of a company.

The three basic financial statements are the

• Balance Sheet: which shows firm’s assets, liabilities, and net worth on a stated date
• Income Statement, also called profit & loss statement or simply the P&L: which shows how the net income of the firm is arrived at over a stated period, and
• Cash Flow Statement: which shows the inflows and outflows of cash due to the firm’s activities during a stated period.

Knowing how to read and understand financial statements is a business skill you can’t ignore. It can help working your way up the corporate ladder by communicating with others in your company and understanding the big picture.

When you are thinking about possibly changing jobs and working for a company you can check their financials and make sure they are a healthy organization. If you are considering starting your own company you will need to have financials prepared by your accountant in order to talk to investors, banks and vendors.

If you want to invest wisely in the stock market, analyze the competition or benchmark your performance, you can look up the financials of any publicly traded company at the Securities and Exchange Commission website’s’ EDGAR filings and get an idea of how they are doing. Check out any public company’s most recent 10K filing there.

This will be a series of posts that will go over each of the financial statements individually and how they are interrelated. The next post will go over the Balance Sheet. Stick with me on this series of posts and level up your business chops. Please leave any comments!

If you are interested in a thorough understanding of these concepts check out my books Learn Accounting Fast! or Reading and Understanding Financial Statements.