startup finances

MONASHBUSINESSSCHOOL

Finances

Fiona McNabb, Industry Fellow, Department of Banking & FinanceFiona.mcnabb@monash.edu

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Overview

§ Discovering the bottom line– Costs, pricing and break even

§ Managing Start-up Equity– Vesting, cliffs, acceleration and valuation

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Overview

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Crunching the numbers

§ Prospective investors are mainly interested in the bottom line– What profits and cash flows will the business generate?– What is my required return?– How much of the business do I need to own?– What is my exit strategy?

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Successful Venture Life Cycle

Stages of a successful venture’s life from development through various stages of revenue growth

1. Development Stage:– period involving the progression from an idea to a promising

business opportunity2. Startup Stage:

– period when the venture is organized, developed, and an initial revenue model is put in place

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Successful Venture Life Cycle

3. Survival Stage:– period when revenues start to grow and help pay some, but

typically not all, of the expenses4. Rapid-Growth Stage:

– period of very rapid revenue and cash flow growth5. Maturity Stage:

– period when the growth of revenue and cash flow continues but at a much slower rate than in the rapid-growth stage

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VC life cycle

Source:EntrepreneurialFinance,Leechetal

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Types and sources of funds

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Family and friends

§ First funding usually from the “three Fs”§ Friends, family and fools§ Investing first so highest returns

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Business Angels

§ Angel investors invest in start-ups. The capital angel investors provide may be a one-time investment to help the business propel or an ongoing injection of money to support and carry the company through its difficult early stages.

§ Examples:– http://melbourneangels.net/– http://scaleinvestors.com.au/– This program

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Venture Capital

§ Venture capital is financing that investors provide to start-up companies and small businesses that are believed to have long term growth potential. For startups venture capital is an essential source of money. Risk is typically high for investors, and VC investors usually get a say in company decisions.

§ Typically manage a portfolio of start-up investments§ Examples:

– http://www.acorncapital.com.au/– http://www.starfishvc.com/– http://contango.com.au/– https://www.trimantium.com/–

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Finance principles for start-ups

1. Real, Human, and Financial Capital Must be Rented from Owners

2. Risk and Expected Reward Go Hand in Hand3. While Accounting is the Language of Business, Cash is

the CurrencyNew Venture Financing Involves Search, Negotiation, and Privacy

4. A Venture’s Financial Objective is to Increase Value5. It is Dangerous to Assume that People Act Against Their

Own Self-Interest6. Venture Character and Reputation Can be Assets or

Liabilities

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The Bottom line

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The bottom line

§ Start-ups are usually:– Burning cash– Not making profits in the short term– Takes time to break even

§ Why invest?– Long term prospects for growth

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Cash Burn and Cash Build

§ Cash Burn:– cash a venture expends on its operating and financing expenses

and its investments in assets§ Cash Burn Rate:

– cash burn for a fixed period of time, typically a month§ Cash Burn = Inventory-related expenses + Admin

expenses + Marketing expenses + R& D expense + Interest expenses + Change in prepaid expenses –(Change in accrued liabilities + Change in payables) + Capital investment + Taxes

§ Cash Build = Net sales – Change in receivables§ Cash Build Rate:

– Cash build for a fixed period of time, typically a month§ Net Cash Burn = Cash burn - Cash build

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Forecasting

§ Need to forecast sales, variable costs and fixed costs over, say, 5 to 7 years, until business is at rapid growth or (preferably) maturity stage

§ Also include development costs.§ Expect negative cash flows for the first few years§ See my Softtec example

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Operating leverage

§ Operating leverage is a measure of how revenue growth translates into growth in operating income

§ It depends on sales and costs– In particular, fixed versus variable costs

§ If variable costs are low, profit varies more with sales.

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Example: Austral Carbonlite and Fibrespeed Corp.

Notelowerfixedcosts,highervariablecosts

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Austral Carbonlite Inc. Versus Fiberspeed

Carbonlite Inc Fiberspeed CorpSales volume 10,000 sofas 10,000 sofas

Price $1,000 $1,000

Total Revenue $10,000,000 $10,000,000

Fixed costs per year $5,000,000 $2,000,000

Variable costs per frame $400 $700Total cost $9,000,000 $9,000,000EBIT $1,000,000 $1,000,000

11,000frames11,000frames

$11,000,000$11,000,000

$9,700,000$9,400,000

$1,300,000$1,600,000

• Whatifsalesvolumeincreasesby10%?• AustralCarbonlite’s EBITincreasesfasterbecauseithashighoperating

leverage.

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Operating Leverage for Austral Carbonlite and FibrespeedCorp

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Valuation

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Valuing Start-ups

§ Valuation is difficult– High risk that the venture won’t succeed– Initial negative cash flows

§ Value of a company– Present value of all cash flows received– For an investor, it’s all about $– Assumptions and forecasting

§ Future cash flows§ Risk

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Venture Capital method

§ VC contributes and investment and has a required return over investment period.– For example, $1m for 3 years with a required return of 30%– Exit value = 1m(1+.3)3 = $2.197m– They invest $1m with the expectation or receiving $2.197 in the

future.§ Estimate value at exit

– Typically a multiple of P/E or EBITDA– In this example, P/E multiple is 10, final earnings E = $0.25m– Value in 3 years estimated at $2.5m.

§ How much ownership does VC get– 2.197/2.5 = 88%

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Venture Capital method

§ But staff will need some incentives too – Grant them 300,000 shares– Vesting in 3 years

§ If there are 1m shares on issue before the capital injection, VC gets – 1m/(1-.88) = 8.25 shares– Total number of shares = 9.25m shares

§ Staff get 300,000 shares, which is 3.2%§ Owners keep 700,000 shares, which is 7.6%

– Ownership diluted!

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Example

§ A venture capitalist firm wants to invest $1.5 million in your NYDeli dot.com venture that you started six months ago. You do not expect to make a profit until year four when your net income is expected to be $3 million. The shares of BioSystems, a “comparable” firm, currently trade in the over-the-counter market at $30 per share. BioSystems’ net income for the most recent year was $300,000 and the firm has 150,000 shares of common stock outstanding.

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Example (2)

A. Apply the VC method to determine the value of the NYDeli at the end of four years.

B. If VCs want a 40% compound annual rate of return on similar investments, what is the present value of your NYDeli venture?

C. What percentage of ownership of the NYDeli dot.com venture will you have to give up to the VC firm for its $1.5 million investment?

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Example continued

A. Apply the VC method to determine the value of the NYDeli at the end of four years.

§ Comparable’s EPS = $300,000 / 150,000 = 2§ Comparable’s P/E = 30/2 = 15§ Venture’s projected value at year 4 = 15 * 3,000,000 =

45,000,000

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Example continued

B. If VCs want a 40% compound annual rate of return on similar investments, what is the present value of your NYDeli venture?

§ 45,000,000 / 1.4^4 = 11,713,869

C. What percentage of ownership of the NYDeli dot.com venture will you have to give up to the VC firm for its $1.5 million investment?

§ 1,500,000 / 11,713,869 = 12.81%

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Summary

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Summary

§ This a very brief overview§ Need a knowledge of accounting practices and finance§ It’s all about the cash flows

– Forecasting cash flows– Understanding the risks– Knowing where to access funds, depending on your lifecycle

stage.

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