Financial Projections

For Start‐upsFor Start ups

Prof. Thomas HellmannUniversity of Oxford © 2014

• Magic mirror in my handMagic mirror in my hand, who is the fairest in the land?

• My queen, you are the f i hfairest here so true. B t S Whit h• But Snow White has a thousand times morethousand times more EBITDA than you.y

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milestonesBusiness

Plan milestones, scale and

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Second Mirror ImageSecond Mirror Image

Process ofProcess of generating FP

L i forces entrepreneurs to

Learning about Self entrepreneurs to

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Third Mirror ImageThird Mirror Image

FP reflect to in estors theinvestors the business prospects

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financial literacy and Investors

conceptual clarity

LimitationsLimitations• Financial Projections are always wrong

– Unpredictability of start‐ups– Timing hard to guess

B f f l i i– Beware of false precision

• Financial Projections are always out of dateGood entrepreneurs change strategy often– Good entrepreneurs change strategy often

– Lean start‐ups ‘pivot’

• Financial Projections are always optimisticFinancial Projections are always optimistic – Code language:  “our projections very conservative”– Investors expect optimistic projections– Describe the ‘good case’, not the ‘average case’

• Financial Projections are not a substitute for proper financial kaccounting record keeping

HOW TOHOW TO DEVELOPDEVELOP FINANCIALFINANCIAL PROJECTIONS?PROJECTIONS?

A Fine RecipeA Fine Recipe

Use two pounds of fresh primary market research

Mi i f d k d Mix in a cup of secondary market data

Lightly sprinkle some theoretical reasoning Lightly sprinkle some theoretical reasoning

Decorate subtly with wishful thinking

Serve hot

Basic StepsBasic Steps• Project RevenuesProject Revenues• Project all costs

Cost of good sold Expenses Development costs– Cost of good sold, Expenses, Development costs, Taxes, etc…

• Build projections• Build projections– Cash Flow StatementI St t t– Income Statement 

– Balance Sheet

f l• Present financial projections• Manage cash 

REVENUEREVENUE PROJECTIONSPROJECTIONS

RevenuesRevenues  P i * V l= Price * Volume

Define counting unitDefine counting unit• Define unit sale• Use ‘average’ transaction • Examples• Examples

– MuseumRestaurant– Restaurant

– Online newspaperO li id– Online video game

– Nuclear power stationF hi lt t– Fashion consultant

– Military subcontractor– Etc…

Estimating PricesEstimating Prices• Customer–centric 

– Value proposition– Willingness to pay– Customer segmentation

• Competitor‐basedp– Cost‐quality comparison – Market dynamicsMarket dynamics– Initial pricing strategy

• Value‐chain constraints• Value‐chain constraints

Supplier t $2

Production costs 

(COGS)

Price to distributor 

Price to retailer = 

Average discounted  t il i

Suggested retail price costs = $2 (COGS) = 

$5

d st buto= $9

eta e$15 retail price 

= $24

eta p ce= $30

Estimating QuantitiesEstimating Quantities

h• Four approaches

1. Top‐down2. Bottom‐up3. Copy‐cat3. Copy cat4. More‐of‐the‐same

• In practice use combinationIn practice, use combination

The S curveThe S curve

Revenues

Time

Top down revenue projectionsTop down revenue projections

Top down revenue projectionsTop down revenue projections• Define relevant market segmentg• Existing markets:

– Look up current market revenues– Project market growth rate– Estimate obtainable market share

• (Hopefully) Emerging markets:– Estimate potential market size

Estimate market adoption curve (S curve)– Estimate market adoption curve (S‐curve)– Estimate obtainable market share

• Classical mistakes:Classical mistakes:– “Everybody in China will buy our product”– “We only need 1% of a $1Billion market”

Example: Asia Renal Carep

China Taiwan China / TaiwanPopulation (in mil) 1199 21 57.10Treatment rate 19 630Incidence rate (in mil) 629 630People with ESRD 754171 13230 57.00Urban population 30 00% 100 00%Urban population 30.00% 100.00%Urban ESRD 226251 13230 17.10Insured 30.00% 100.00%Insured Urban ESRD 67875 13230 5.13Price per treatment $53 $156 0.34Average yearly visits 130 130Annual revenue per patient $6,890 $20,280 0.34Total market size $467 661 437 $268 304 400 1 74

Based on “Asia Renal Care” HBS Case Study 9-800-243

Total market size $467,661,437 $268,304,400 1.74

Bottom up revenue projectionsBottom‐up revenue projections

Bottom up revenue projectionsBottom‐up revenue projections

• Basic idea–Define basic unit of product / serviceDefine basic unit of product / service– Estimate customers purchasing units –Multiply by average price– Estimate customer growth over time– Estimate customer growth over time

• Approach focuses on ability to deliver!

Example: Fast CevicheExample: Fast Ceviche• Revenues from typical customer

– Ceviche + side dish + drinks = £10

• Number of customers and hours of operationsL h 50 t– Lunch: 50 customers

– Afternoon: 20 customers– Evening: 50 customersEvening: 50 customers 

• Number of days in operation– 5 days a week; 48 weeksy

• Total annual revenues– £10 * 120 = £1,200 daily revenues– £1,200 * 5 = £6,000 weekly revenues– $6000 * 48 = £288,000 yearly revenues

• Ramp‐up to total revenues?

Combining Top Down and Bottom UpCombining Top‐Down and Bottom Up

• Construct Market Share: MS = BU / TD• Construct Market Share: MS = BU / TD– BU = Bottom up counting– TD = Top down market sizep

• Case 1: MS < 10%– Small market share– Market segment defined too broadly– Bottom‐up strategy too conservative

• Case 2: 10% < MS < 100%– Is market share realistic?

F MS > 50% h d i t th k t– For MS > 50%: why can you dominate the market  

• Case 3: MS > 100%– Stop dreaming: market doesn’t support growth strategy– Stop dreaming: market doesn t support growth strategy  

Copy Cats and More of the sameCopy‐Cats and More‐of‐the‐same

Copy Cats and More of the sameCopy‐Cats and More‐of‐the‐same

• Industry comparables

• Competitor comparables 

• For established businesses: use own recent growth rates

• Past performance is not a reliable indicator of future performance

• Works best at top of S‐curve 

The S curveThe S curve

Revenues

Over-estimate rapid growth

R bl ti t fReasonable estimates of stable growth

Under-estimate early growthUnder estimate early growth

Time

COSTCOSTPROJECTIONSPROJECTIONS

27

Cost of goods sold (COGS)Cost of goods sold (COGS)

• Estimate cost of sourcing physical inputs• Estimate cost of sourcing physical inputs• Express as % of sales, but...

• With “increasing returns to scale” COGS decrease with volume, due to input fixed costs, volumewith volume, due to input fixed costs, volume discounts, etc…

• With “decreasing returns to scale” COGS increase• With  decreasing returns to scale  COGS increase with volume, due to capacity constraints

E ti ti th d• Estimation methods• Direct cost estimates from suppliers and experts • Inferred from competitor cost ratios

ExampleExample

C ff C t l t Coffee Cheapo:Coffee Costalot: Market leader

Coffee Cheapo: Start‐up challenger

Price of standard cup: £4f

Cheaper price: £3Cost of good sold: £2COGS / Revenues = 50%

Use Costalot ratio: 50%Cost of goods sold: £1.5

Gross margin of 100% Profit of £2 per cup

Gross margin of 100% Profit of £1 5 per cupProfit of £2 per cup Profit of £1.5 per cup

ExampleExample

C ff C t l t Coffee Cheapo:Coffee Costalot: Market leader

Coffee Cheapo: Start‐up challenger

Price of standard cup: £4C f d ld £2

Cheaper price: £3Cost of good sold: £2COGS / Revenues = 50%

Use Costalot ratio: 50%Cost of goods sold: £1.5

Gross margin of 100%Profit of £2 per cup

Gross margin of 100% Profit of £1 5 per cupProfit of £2 per cup Profit of £1.5 per cup

ExampleExample

C ff C t l t Coffee Cheapo:Coffee Costalot: Market leader

Coffee Cheapo: Start‐up challenger

Price of standard cup: £4f

Cheaper price: £3Cost of good sold: £2COGS / Revenues = 50%

Realistic COGS: £2.40COGS / Revenues = 80%

Gross margin of 100%Profit of £2 per cup

Gross margin of 25%Profit of £0 5 per cupProfit of  £2 per cup Profit of £0.5 per cup

ExpensesExpenses• Cost of facilities and equipmentq p

– Rent/lease: recurring expense– Own: one‐time capital expenditure

• Labour expenses– Salary, Benefits, Training costs, Bonuses

S k i ?– Stock options?– Founder salaries?

• Other expenses• Other expenses– Marketing and Sales– Legalg– Admin Overhead– Etc…

Budget for founder salaries?Budget for founder salaries?

• Before outside financing, founder salaries largely meaningless

• Outside investors not too fond of paying high salaries in early stages

• Founders need to set expectations that one day they want to eat something better than Ramen soup!a o ea so e g be e a a e soup– Write employment agreement– Define founder salaryDefine founder salary – Take reduced salary for initial years

Development cost projectionsDevelopment cost projections• “Mundane” set‐up costs 

– Legal, Licenses, Office space, Basics 

• Pre‐revenue development planSh f– Short for restaurants

– Long for biotechs

• Main development costs• Main development costs – Employees (see expenses)– Capital expenditures (e.g. equipment)p p ( g q p )– Cost of licensing‐in technology, protecting IP

• Define milestones and timing – Define demonstrable progress markers

• Prototype, Beta customers, etc… 

Diffi lt f di ti ‘ i t ’– Difficulty of predicting ‘pivots’

Taxes etcTaxes etc…

• Taxes to be paid– VAT– Corporate taxesIndustry specific levies– Industry specific levies

• Tax credits– Differ by country, industry, over time, etc…

• Other• Other– Interest payments

Example of “operating stacks”Example of  operating stacks

90%

100%

10%

15%

60%

70%

80%

40%

Net earnings

Overhead

M&S

R&D

30%

40%

50%

15%

R&D

COGS

0%

10%

20% 20%

0%% of revenues

INTEGRATEDINTEGRATED PROJECTIONSPROJECTIONS

Some useful linksSome useful links• Stanford Technology Venture Formation

http://www.stanford.edu/class/msande273/resources.html

– Peter Kent’s financial model (too complex)

– Jeff Kuhn’s model (too simple)

• Hellmann Model

http://strategy.sauder.ubc.ca/hellmann/

– Goldilocks says: (Just right) 

• WWW

– Lots of models freely available

Fundamentals versus Pro Formas• Fundamental projections:

– Bring together all revenues and costs– Pay attention to timing of cash flows

• Pro Forma statements: – Income Statement (a.k.a. Profit and loss statement)

• Establish viability & profitability

– Cash flow statement• Determine financial needs • Monitor survival

B l h t– Balance sheet • Estimate “book value”• Resilience• Resilience 

How long, how often, how detailed?How long, how often, how detailed?• Length

– Minimum 1‐2 years; typical 3‐5 years; maximum ???– Minimum 1‐2 years; typical 3‐5 years; maximum ???– Depends on industry and development cycle

• Retail: a few months• Software: a few years• Biotech / Cleantech: a few decades

• Frequency• Frequency – Monthly: “only the paranoid survive”– Quarterly: “balanced approach”; still captures seasonalityQuarterly:  balanced approach ; still captures seasonality– Yearly: “big picture”

• Detail– In a presentation only shows highlights– Be ready for justifying each number!

Cash Flow Forecastingg

45000

Quarterly Cash Balances Monthly Cash Balances

40000

45000

35000

40000

45000

30000

35000

25000

30000

35000

20000

25000

15000

20000

25000

5000

10000

15000

5000

10000

0

5000

Q1 Q2 Q3 Q4 Q5‐5000

0

CASH FLOWCASH FLOW MANAGEMENTMANAGEMENT

Working capitalWorking capital

• Working Capital = Current assets – Current liabilities

• If working capital positive: cash burn!g p p

– Need cash to run the business

• If working capital negative: cash machine! 

– Get paid before delivering servicesp g

• In growing business, positive working capital means cash burn 

increasing over time

• Beware of the fume date!!!Beware of the fume date!!!

Hellmann’s HaikuHellmann s Haiku

TAMO = Then A Miracle OccursTAMO = Then A Miracle Occurs

Trade credit• Prerequisites 

R h i– Repeat purchasing – Good customer standing

• Standardized terms (industry specific)Pay in less than x days to get discount (1 d)*p– Pay in less than x days to get discount (1‐d) p

– Pay in less than y days and pay in full (p)– Pay in more than y days and pay incur penalty

• Trade credit looks attractive to cash‐constrained entrepreneursT d dit b i i l i• Trade credit can be surprisingly expensive– Do the math!!!

Implied capital cost of trade creditImplied capital cost of trade credit

Discount

1% 2% 3% 5% 10%

15 27.28% 62.40% 107.72% 242.48% 1153.66%

30 12.82% 27.43% 44.12% 85.06% 254.07%

ExtraDays

45 8.37% 17.54% 27.59% 50.73% 132.31%

60 6.22% 12.89% 20.05% 36.04% 88.17%

90 4.10% 8.42% 12.96% 22.77% 52.42%

120 3.06% 6.25% 9.57% 16.64% 37.17%

CLASSICCLASSIC MISTAKESMISTAKES

Classic mistakes (I)• Revenues

Overestimate speed of revenues– Overestimate speed of revenues– Unjustifiable revenue spurts– Missing costs of generating sales– Distinguish listed and actual average priceg g p

• CostForget costs of running business– Forget costs of running business

– Plan for underutilized assets– Full labor costs

• including benefits, training, bonuses, etc…

Classic mistakes (II)

• Cash flows– Late payments and collection costs– Underestimate true cost of trade credit– Underestimate delays in raising funding

• Overall• Overall– Ignore industry norms– False precision– Too much detail– Mismatch between financials and business plan

Final words of wisdomFinal words of wisdom

C h flCash flows are more important pthan your mommy!

Thank You!Thank You!

• Thomas Hellmann• Professor of Entrepreneurship and Innovation• Saïd Business School, University of Oxford • Park End Street, Oxford OX1 1HP, UK• T: +44 (0)1865 288937• thomas.hellmann@sbs.ox.ac.uk

APPENDIXAPPENDIX

PRESENTATIONPRESENTATION EXAMPLE #1EXAMPLE #1

Financial Projection$120

$100

$60

$80s

$20

$40

$Millions

$0

$

2012 2013 2014 2015 2016Total Revenue $8,800  $132,800  $864,000  $21,160,000  $99,550,000 Gross Margin ($18,939) ($175,748) ($48,167) $9,971,397  $48,566,526 

‐$20

Total Operating Expenses $2,642,643  $6,339,171  $12,303,334  $21,733,046  $43,654,877 Income Before Int & Taxes ($2,661,581) ($6,514,919) ($12,351,500) ($11,761,650) $4,911,649 

Operating Stacks84% 15%84% 15%

PRESENTATIONPRESENTATION EXAMPLE #2EXAMPLE #2

Financials: Business Model

Unit economics Annual RecurringUnit economics

$

Annual Recurring

Sale Price: $3250 Premium Package: $500

Unit Cost: $1700‐ Goggles / Sensor $950

Annual Costs:‐ Extended Warrantygg / $

‐ Gloves $400 ‐ Accelerometer $350

Extended Warranty‐ Live Tech SupportTraining Website

U it G M i 40%

Accelerometer $350 ‐ Training Website

Unit Gross Margin: 40%

Financial Model: Assumptionsp

• 1Product per Customer • 1Product per Customer

• 50%Uptake of Premium Package                                Uptake of Premium Package                                

• 2%Target Market Entry Share                                     Target Market Entry Share                                     

2% + 1%Growth Rate • 2% + 1%n years Growth Rate

• 10% Annual SalesInventory

• +5% AnnualSalary

Q t lS ft U d t • QuarterlySoftware Updates

• Every 2 yearsProduct Iterations

Profit and LossProfit and Loss$MM Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Unit Sales 0 9 862 1679 2934 5478

Head Count 5 5 8 13 15 21Head Count 5 5 8 13 15 21

Revenue 0 0.03 2.9 6.0 10.7 20.1

Gross Profit 0 0.02 1.5 3.2 5.7 10.7

Gross Margin %

49 49 49 50 51 51Margin %OperatingExpenses

0.8 0.7 1.5 1.9 2.5 3.8

EBITDA ‐0.8 ‐0.7 0 1.2 3.2 6.9

N t I 0 8 0 7 0 0 9 2 2 4 9Net Income ‐0.8 ‐0.7 0 0.9 2.2 4.9

Revenue and Net Income

P b kPaybackX

Break-Even

S d R d 1

Break Even Point

X

Seed Round 1X X

Operating Stacksp g

PRESENTATIONPRESENTATION EXAMPLE #3EXAMPLE #3

R & M k P iRevenue & Market Penetration$152 100%$160

$116

$152 

80%

90%

100%

$

$140 

$160 

Millions

$116 

60%

70%$100 

$120 

$76 

40%

50%

$60 

$80 

$41 

15%23%

30%20%

30%

$20

$40 

8%15%

0%

10%

$‐

$20 

2013 2014 2015 2016 2017 2018 20192013 2014 2015 2016 2017 2018 2019

Revenue Market Penetration

G M kGo to Market

2013 2014 2015 2016 2017

Sales BetaAlpha Distributor Distributor Phase II

13HeadCount 31 67 102 139

Sales customerp

customer Phase I Distributor Phase II

Hardware First release Ongoing developmentShrink

Cou

Rev 2

PACS specific 2 PACS/yearSoftware Mouse, keyboard final

A iAssumptions

25% of all operations

• 50%‐75% of operations use imaging.• Half of those are long enough.

33% Distributor Markup

• Retail price of $112.50• Wholesale price of $75 00Markup • Wholesale price of $75.00

Slow Medical  • 15% penetration in 5 yearsMarket • 30% penetration in 7 years

• No FDA approvalClass I Device

• No FDA approval• 90 day pre‐market notification

Steady Adoption • Growth rate is linear

Fi i l P j iFinancial Projections

$140 

$160 

illions

$100 

$120 M

$60 

$80 

$20 

$40 

$3.4 $9.6 $16.2

‐$20 

$‐‐$1.4 ‐$4.1 ‐$8.6 ‐$0.8

$

2013 2014 2015 2016 2017 2018 2019

Revenue Gross Profit EBITDA

O i S kOperating Stacks

100%26%

14% 15% 18% 18%

80%16%

18%30% 22% 22%

26%

60% 14% 28%21% 25% 26%

20%

40%

45% 40% 35% 35% 34%

0%

20%

2013 2014 2015 2016 2017

R&D Sales/Marketing Operations General & Administrative

F di MilFunding Milestones2013 2014 2015 2016 2017

Res

erve

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4Q1 Q2 Q3 Q4

Series B $

Series C $8.5 MM

Cas

h R $5 MM

Series A $1.5 MM

13HeadCount

31 67 102 139

Hardware First release Ongoing developmentShrink Rev 2

PACS specific 2 PACS/yearSoftware

BetaAlpha

Mouse, keyboard final

SalesBeta

customerAlpha

customer Distributor Phase I Distributor Phase II