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.

Survey says VC's invest on Gut Instinct

Nope, the above quote isn't from Richard Dawson on Family Feud, but similar to a headline that caught my attention on the front page of the business section of the San Jose Mercury News this morning. Not that it was surprising, but that it would be news worthy of this placement. Once I got past the headline, I realized, that Scott Harris had the same reaction to the survey that I did.

He was citing a survey done by John Paglia at Pepperdine University. Harris writes "'Gut Feelings were cited by 67 percent of 185 venture capitalists surveyed, while [discounted] cash flow analysis was cited by 43 percent" as techniques used in analyzing potential investments. It struck me that the 43 percent number for DCF was really high, but if a sizable chunk of the VC's surveyed are late stage, would make more sense. Or perhaps, that is just my west coast bias to
think nobody pays attention to DCF.


I decided to go grab the survey to see if there was more. I pulled the report and buried in table 28 on page 35 is the data cited in the article. The data makes a lot more sense if you look at the entire table. I'd break down into two separate pieces - financial analysis and business/market analysis. On the financial analysis end, you have multiples far and away the most common valuation method over DCF, Simulation and Option analysis. I've never heard of a VC running Monte Carlo simulations on possible outcomes. Either the company is going to be successful, wildly successful or will fail....I always focus on the business model and assumptions, but there are too many unknowns to put much faith in the future cash flow projections.

On the other side, you have Market Analysis (96%) followed by gut (67%). This brings up the age old question on whether you are investing in markets or teams. If you've got a large growing market, solid team, strong competitive position and compelling solution, you'll move forward with diligence, which can range from going with your gut to doing detailed projections, numerous reference calls and deep market analysis.

Let's get back to the topic of gut investing. I was a limited partner in Angel Investors, LP, Ron Conway's fund in the late 1990's. They clearly went on gut and were often accused of drive-by investing, but that has to be the only way to invest in 200 companies over a 3-year period. Luckily, Ron's gut told him to get as much money as he could in to Google, which saved the fund.

I just finished reading Malcolm Gladwell's Blink.






Blink starts with the anecdote of the Getty Museum's $10 million acquisition of a rare Greek statue dating from the 6th century BC. They spent 14 months researching the authenticity. A geologist spent two days examining the statue with a high-resolution stereomicroscope and removed a sample and "analyzed it using an electron microscope, electron microprobe, mass spectometry, X-ray diffraction, and X-ray fluorescence." The conclusion was that it was indeed old.

However, when several experts in Greek sculpture viewed the sculpture, they were all able to see immediately that that it didn't seem right, but couldn't necessarily articulate why. Turns out they were right and the statue was fake. Whether this was gut, natural intuition, or some other subconscious analysis from years in the field, it doesn't matter. The point is their opinions weren't clouded by any vested interest or lengthy analysis.

Certainly, a corollary to VC's who have seen hundreds or thousands of start-ups and can often tell within the first 2 minutes or 2 seconds whether an investment is even a possibility.


Back to the survey. One other chart worth noting is the the expected returns from various private capital providers (Banks, Asset based lenders, Mezzanine, Private Equity and VC). From the chart to the left, you can see that the 42% expected return of VC is clearly an outlier on the graph.

Of course, if you look at the Cambridge Associates data ( graph at the bottom left) comparing venture capital returns of top quartile vs. median funds, you'll see that over the past three decades, the median fund has never returned over 40% and that the returns have been 0% over the past ten years. In looking at that data, if I'm a VC and promising LP's a 42% return, my "gut" might be telling me to to find another job when the fund is done.