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.

How much is enough?

Financing, that is...I had mixed emotions when I read the the press release on the recent funding of iControl Networks.

I was the founding CFO for iControl and spent over 4 years with the company (the reason I call myself a part-time CFO and not interim as I tend to remain longer than most permanent CFO's...) Since the iControl system chronicles all meetings, I was able to find the automatic picture snapped from my first meeting with the founders, Reza Raji and Chris Stevens on April 22, 2004.

Now that iControl has raised over $100M, this got me thinking back to our original business plan. One truth of start-up financing is that it generally takes twice as long and twice as much money to accomplish your milestones. I took a look back at our original financial model we presented to VC's in 2004. The business model (OEM through broadband and home security companies for mass distribution) if not specific product functionality has remained largely the same. But of course, the model had us requiring only $10M equity to breakeven and to achieve $185M in revenues in 2008 (the magic Year 5 in all business plans).

I am no longer an insider, so don't have any view into current financials, but do know that total financing is now 10X the original plan and at the current accelerating growth rate, revenues will still not hit that $185M until 2012 or 2013, so double the time. And this is a company that has managed to get an A+ list of investors and is executing very well. Most companies don't come close to their rose colored financial models prepared when going out for Series A financing.

There are definitely some lessons in the story for entrepreneurs and angel investors, but before discussing, I thought I'd share a bit about the early financing history for iControl. Before the $52M Series D, the $23M Series C, the $15.5M Series B and the $5M Series A, there were angels writing checks with many less 0's. In looking back at the old financials, at the end of Q2 2005, our cash balance was a whopping $546. At this point, Reza and I were funding the company to keep the lights on and servers running. We had spent the $275K raised from our original angels and were actively speaking to any and all angels and VC's we could convince to meet with us. In fact, since the iControl system was busy taking pictures of all entering our conference room, we could put together a photo album of all these meetings.

At this time, we had secured a term sheet from a co-investor from one of my other angel investments (Thanks, Graeme!) offering to invest $75K if we could find another $250K by September 30, 2005. We managed to pull together an angel syndicate and close $450K on 9/30 after working the phones the last few days and anxiously waiting for signature pages to show up on the fax machine and wire confirms to hit the bank account. Less than a month later, we received a term sheet from Charles River Ventures for the Series A and as they say, the rest is financing history...with investments from Intel, Kleiner Perkins, Cisco, GE, Comcast, ADT, Rogers, and others.

So what does this all mean. As I said up front, I have mixed emotions about the financing. While my ownership stake in the company has been diluted through these financings (and the merger with uControl), my carried interest (paper value of my equity) has been going up with each increase in valuation. However, each financing resets the clock as new investors are looking for a multiple of their investment on exit.

Entrepreneurial finance (I should know since I teach the course) is all about options. Staged financing gives investors options in deciding whether and when to invest more and gives entrepreneurs options in how much to raise and when to think about exiting. While bootstrapping, there are multiple options from doing as a side project, changing the business, raising angel or venture, etc. Once you raise a small angel financing, you still keep many of your options, but are now committing to a growth path with an eye towards eventual liquidity. A talent acquisition or bootstrapping are still options, but need to include buy-in from the investors. Once you raise venture capital, you are forced on a path to spend ahead of the business and seek the highest growth business model options. In iControl’s case, there were exit options at different stages, but now with more than $100M invested, the only options where investors will be happy will be an IPO or $1B+ acquisition, which greatly limits strategic options.

Is $120M enough capital to reach these exit goals? I sure hope so, but we'll have to wait and see how the founding team and angels come out at the end of the day. Stay tuned...