Subject line: [Flawless Financials] Financial Summaries Flawless Financials the Financial Forecasting Online Newsletter from Minotaur Financial and David Brode August, 2003 Please pass on Flawless Financials to those in your network. To leave Flawless Financials, follow instructions at bottom. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * This month: Financial Summaries * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * I. Innumeracy: People Don't Read Numbers Well Many investors simply skip over financial projections. Others examine the page, but can't extract much information beyond the revenue ramp and overall profitability forecasts. This is a shame, given how much work goes into the financials—and how powerfully they can communicate your message. Recently, I've found investors react well to a Financial Summary that precedes the detailed financial model. The main imperative here it to keep the information simple; reviewers can't or won't read a solid page of numbers. So what do effective Financial Summaries look like? First, they are short. One page is ideal; two pages is the maximum length. Aside from being concise, the summaries I've done have varied quite a bit. Below I'll review what features they share. II. Financial Summary Components We have standard formats for income statements, balance sheets, and cash flow statements, and within those structures there's room for art. For example, an income statement will show Revenue, COGS, Gross Profit, EBIT, and Net Income. But what else goes onto the IS? That's where the art comes in: do you show components of revenue, and which ones? How should expenses be broken out? People who review many plans see a wide variety of line-items that communicate important information about the business -- it's easier to get that message because the overall structure of the document is familiar. The key is standardization. What I'm proposing here is the equivalent structure for a Financial Summary with four categories: - Investment - Use of Funds - Business Model - Projections Each of these four components is discussed below. Investment. This is information about the sources of money for the company, specifically the equity capital. This includes the current investment amount being sought, the total equity capital needed over the life of the company, and investor returns (dollars, IRR, cash return multiple). Let's face it: this is always critical information. You have to be clear about how much money you want and investors need to see compelling investment returns to stay interested. While some companies choose not to display some of this information initially, it always comes out before a term sheet is agreed upon. Use of Funds. The purpose of this section is to answer the question, "How are you going to use my money?" This should quantify your story of the key next steps you are taking in the upcoming 12-24 months to bring the company towards a steady state profitability. This section should consist of a simple list of 4-8 categories with dollar amounts next to them. (My pet peeve in this is the "Contingency" category. The total should add to the funds invested; extra money can be lumped into "Working Capital" or "Cash," each of which sounds better than "Contingency".) Business Model. This is distinct from the financial projections, which are covered below. The business model is a short quantitative description of your business. It describes the longer term steady state operations with the goal of having investors understand the gold mine of a business you're offering them. For many companies, the business model shows the economics of capturing and servicing a single customer. For example, (part of) Microsoft may look like this: R&D Investment: $10,000,000 Customers: 1,000,000 Revenue/Cust. $100 Revenue: $100,000,000 COGS: $1,000,000 SG&A $40,000,000 EBIT $59,000,000 Pretty clear, huh? Done well, this tool help you have an intelligent conversation with investors. You can discuss the range of R&D spending. You'll probably spend an incredible amount of time on market size, customers, and pricing. And the SG&A needs some detail, but typically it can be bounded nicely. So even though the business operations are incredibly complex, the basic business model is usually quite simple. Projections. This is the core material of what most people think of as "The Financials." For a Financial Summary, you want to hit the highlights. Classic measures include: Revenue Gross margin EBIT EBIT margin Headcount Rev/HC Cash CapEx Customers Although this list will be specific to a business plan, it should show how the line items change over time and lend credibility to the overall package. III. The Four Messages and Financial Summaries Remember the 25-Point Financial Model Scorecard from a few months back? That approach focused on four messages you want to communicate with the numbers: (1) clear investor returns, (2) high financial IQ, (3) credible revenue forecasts, and (4) proving profitability. The matrix below shows how the four categories in a Financial Summary match up against these four messages. | Use Of | Bus. | Investment | Funds | Model | Projections -------------|--------|-------|------------- Clear Investor Returns X High Financial IQ X X X X Credible Revenue Forecasts X Proving Profitability X X X The Investment category maps one-to-one into the Clear Investor Returns message. These basic numbers will always be part of the discussion. Use of Funds is concerned with your knowledge and presentation of how you're spending money while you are unprofitable. High Financial IQ is part of everything you do with numbers, and here it focuses on what you can get done in the short-term given a limited amount of money. (Additionally, High Financial IQ remains an important meta-message around the financials and should come through in how you think about each category.) The Business Model assumes you have a customer and discusses how that customer is profitable for you. This is a critical place to demonstrate High Financial IQ, as no investor wants to fund a guy who doesn't know how his own business works. I mainly see this section as cost- and capex-focused, and that's why I checked Proving Profitability--but not Credible Revenue Forecasts. Yes, customer acquisition costs can be a critical assumption, but I see the business model as explaining to people how you'll make money from a dollar of revenue. The Projections pull it all together, and should pay special attention to market size and revenue to support the Credible Revenue Forecasts message. Just like High Financial IQ applies across all Financial Summary categories, the Projections section needs to send all the messages, which is part of why people get tied up doing them! IV. Uniqueness: Business Model So what's unique here? I think it's the Business Model section. It gets people away from discussing whether you can be $20M or $50M and instead first focuses the discussion on whether this business even makes sense in the long term. Once that's agreed upon, it's easier to focus on how to get to this—now shared— goal. Until next month, all the best, David Brode – Minotaur Financial Removing Financial Issues as a Deal Roadblock * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * WHAT I'M READING The Culpepper Bulletin discusses high-tech compensation surveys and financial benchmarks. The bulletin’s home page is at http://www.culpepper.com/eBulletin/default.asp and from there you can read the archives or sign up for future issues. Recent articles include: - Back from the Rabbit Hole: Profits Beat Growth - Insights on Financial Ratios: A Comparison of Four High-Tech Industry Sectors - Compare Expenses Against Gross Profits, Not Revenue * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * NEWSLETTER ARCHIVE AVAILABLE Make sure to visit the Minotaur Financial website for the Newsletter Archive at http://www.brode.net/resources/ * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * http://www.brode.net mailto:David@Brode.net 1919 14th Street, Suite 510 Boulder, CO 80302 (303) 444-3300 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * ABOUT DAVID BRODE I’m a financial modeling specialist. Over the last fifteen years I’ve completed dozens of models and certainly thousands of versions to support corporate development, M&A, strategic planning, and debt and equity transactions. These models have raised over $1B in debt and $100M in venture capital and private equity. Over time I’ve consistently revised software tools and work processes to get the job done quickly and well. If you have a financial forecasting issue, I’d love to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * (c) 2003 Minotaur Financial, All rights reserved. You are free to use material from the Flawless Financials newsletter in whole or in part, as long as you include complete attribution, including a live web site link. Please also notify me where the material will appear. The attribution should read: "By David Brode of Minotaur Financial. More articles on financial forecasting can be found at http://www.brode.net " * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Are you struggling to convince others to do a deal which you think is a no-brainer? To discuss how you can take numbers off the table as a deal roadblock, call (303) 444-3300. I'm very accessible and glad to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * DO YOU LIKE THIS NEWSLETTER? You are welcome to share this email with colleagues who would benefit from better numbers. Your feedback is always welcome and appreciated. Write in to mailto:feedback@brode.net. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * PRIVACY POLICY: I never rent, trade, or sell my email list to anyone for any reason whatsoever. You'll never get an unsolicited email from a stranger as a result of joining this list. To SUBSCRIBE FREE to this newsletter, send an email to mailto:subscribe@brode.net. And you'll get Minotaur's Financial Forecasting White Paper in the deal. To be REMOVED from this list, send an email to mailto:remove@brode.net. (Please note that this message needs to come from the email address that originally subscribed. If you need help determining this, please email mailto:David@Brode.net.)