Friday, August 26, 2011

Waah...Do I have to build a financial model?

I get asked this question a lot by entrepreneurs (and students). I often feel like a Dad (which I am to two wonderful teenage daughters) when I respond, "Yes, because I say so"...Everyone seems to know someone who has raised huge amounts of venture capital without ever putting together even back of the envelope projections. The objections range from "it's hard", "nobody believes them" to "all hockey sticks look alike". To that last one, there is certainly some truth as the standard time vs. revenue chart in most business plans looks like this:

I'm not teaching Entrepreneurial Finance this semester for the first time since Fall 2007. However, I am teaching the ELAB and a new experimental course (The Silicon Valley Experience) for the MBA program. Since I won't have the opportunity to lecture students on this topic until the spring semester, I'll share some of my thoughts here and perhaps can have a dialog on the topic. High level, building the financial model forces the entrepreneur to:
  1. Validate the concept and business model
  2. Determine financing needs and key milestones
  3. Build credibility with investors
I used to also argue that it supports your proposed valuation, but on an early stage deal that is a bit far fetched to get in to a valuation discussion based on your pro-forma projections. The importance is what is behind the numbers. How do you think? What are the key drivers and metrics? Is the model consistent with the business plan? Does the business model make sense? Do you understand the business and market? The process of building the model forces you to answer the difficult questions related to the business model and give a complete picture of the opportunity. Most importantly, how are you going to make money? What did you expect from a long time start-up CFO?

Related to this, I got an email from an entrepreneur this week interested in meeting with me. Unfortunately, I don't have time to take all of these requests, but always try and help where I can so offered to respond by email. Thought it would be appropriate to share his questions and my answers below related to the topic at hand:

The main questions have to do with presentation of documents to VC's.

1.) Does a complicated sales build model make sense for a pre-revenue SaaS company? Analyzing each step of who comes to the website organic, paid, conversions etc

[SB] Having a bottoms-up model is helpful. Of course, this is all hypothesis at this point, but you want to make sure that your assumptions are consistent with market realities for other SAAS companies. Byron Deeter has a good blog post on SAAS metrics.

2.) How should you include market comps? I don't like doing top down models, but I want to make sure the numbers are based on the other people in the markets.

[SB] It is good to have a top down that is consistent with your bottoms-up, so I’d recommend doing both.

3.) How much needs to be shown in the form of a cashflow statement, and balance sheet? Also, do you show accounts payable/receivable in these as they are not accurate or real?

[SB] I include all of the statements in my models to be complete, but nobody should care about this on a prospective basis. For actuals or short-term projections, much more important. When I look at a model, I care most about the assumptions around the business model. I want to get a good idea of the drivers and what is most important for success. I also want to know how you think about the business and how well you know the market, which becomes apparent through how the model is constructed.

4.) Would you put the assumptions/variables on one page that drives the numbers throughout the spreadsheet, or do you put them above each month so they can be altered monthly.

[SB] Ideally, it is good to have all of the assumptions in one tab, so it makes it much easier to do sensitivity analysis. I like to have one tab with assumptions and one tab with summary financials and key metrics. If the model is constructed properly, you don’t really need to look beyond these. I also typically, write a text document summarizing the assumptions, validation for the assumptions and key metrics. However, sometimes (particularly in the early periods when annual is too long a period), you may want to have some of the assumptions on a monthly basis within the appropriate tab. I often do this in the revenue tab.

Hope that was some helpful advice from ProfessorVC. Feel free to chime in with your thoughts.

I'm heading up to the mountains with the family this evening and should probably get ready for that other common Dad question coming from the back seat, "When are we going to be there?"

One final note: After labeling myself as "the last blogger in Silicon Valley", I am now doing the same thing on twitter. Wanted to make sure it was going to catch on...You can follow me @professorvc, and hopefully will comment more frequently than this blog.