Subject line: [Flawless Financials] Assumptions Tell The Story Flawless Financials the Financial Forecasting Online Newsletter from Minotaur Financial and David Brode July, 2003 Please pass on Flawless Financials to those in your network. To leave Flawless Financials, follow instructions at bottom. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * This month: Assumptions Tell The Story * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * -- Assumptions Trump Outputs -- An effective financial forecast doesn't just show attractive returns to investors. After all, anyone can type 50,000,000 in the cell for Year 4, show a fabulous exit value, and calculate 50% IRRs with 12x return on cash invested. Because it's so easy to create this picture, some reject financial forecasts entirely. I retain my belief in modeling because, when done properly, it describes a series of coherent assumptions that either lend credibility or discredit a possible deal. You can improve your models by focusing on how elegantly you present your most basic assumptions. These may be prices, gross margins, sales & marketing expenses per new customer, revenue per sales head, and many other metrics. What you seek are the handful of high-level assumptions that impact cash requirements and, therefore, investor return. Following are three examples of how to make your assumptions tell a coherent story. -- Technique #1: Explicit Assumptions -- At the most basic level, you're working in a spreadsheet. The glory of a spreadsheet is its accessibility: it's very easy to start working on a forecast. The evil twin of this accessibility is that it is easy to create a forecast without clear assumptions. Most experienced modelers know that finding and changing assumptions is essential to good forecasts. So do something to make them stand out: make inputs blue or make them yellow cells with blue borders, just do something so you and others can find the critical input cells. All this talk of making the assumptions a more explicit part of the story is lost if you can't find the input cells. And please, don't hardcode numbers inside formulas, because the first part to making clear assumptions is making them visible. -- Technique #2: Hiring Plans -- For most businesses, the pre-revenue stage is planned as a series of milestones measured against time and cash requirements. The harsh tradeoff of this period is that there's so much work to be done that requires staff, but people-related costs can be over 80% of the pre-revenue cash burn. Thus the critical document during this period is the hiring plan. The plan shows when people are hired, the position, salary, burden, and other headcount-related costs. And of course you should be able to explain the timing of hiring within the context of the planned milestones. There are so many moving pieces inside the hiring plan that it isn't traditionally thought of as one assumption, but many startups find this class of decisions to be a critical assumption. The hiring plan also supports the size of the option pool. Often investors push to have a larger option pool prior to investing, diluting the pre-money valuation per share to existing shareholders. The hiring plan—with estimated amounts of equity required for each position—justifies the size of the options pool. A rule of thumb is that the pool should be sufficient for all hiring needs in the next 18-24 months. -- Technique #3: Deal Size -- Assumptions can add support to revenue forecasts. Credible revenue forecasting is one of my recurring themes, because you have to believe the revenue streams are realistic in order to be willing to invest in a business. Typically plans forecast revenue as price times quantity and you adjust the number of customers to drive the units and revenue. This simplistic thinking shows revenue as coming from many similarly-sized deals, and as revenue rises the number of deals can look huge and unobtainable. Recently I worked with an enterprise software startup who we compared to Rational and Mercury. We found that in Q1 2002, - Rational generated 63% of their revenue from 2.4% of their deals. - Mercury generated 93% of their revenue from 12.6% of their deals. - In both cases, those deals represented those larger than $100,000. Further analysis revealed that, interestingly, the $100,000 to $1,000,000 deals, not the humungous deals (>$1M) are the ones that account for this revenue. Again, the data: - Rational generated 55% of their revenue from the 2.3% of deals between $100K and $1M. - Mercury generated 88% of their revenue from 12.4% of deals between $100K and $1M. Bringing this data into the presentation served a number of purposes. First, it provided validation to our assumptions about the number of seats per customer in the out years. Second, it told us how many customers and deals we needed in order to hit revenue targets, and third that information suggested the kind of sales & marketing that the organization needed: it takes experienced, highly compensated people to close $250,000 deals, not just a website and telemarketers. -- A Global View -- Breaking down the overall economics into key assumptions is a huge timesaver in discussions which cross the strategy/finance boundary. For a recent client we broke her profitability into ten metrics—6 revenue drivers and 4 expense drivers. Now when we discuss changes in strategy we can quickly see which driver it impacts and by understanding the range of possible values, we know how large an impact such a change will have. Do you know the ten assumptions/metrics on your company or most recent deal? Until next month, all the best, David Brode – Minotaur Financial Removing Financial Issues as a Deal Roadblock * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * WHAT I'M READING Bill Gurley joined Benchmark Capital in 1999 after spending two years as a partner with Hummer Winblad Venture Partners. The Above the Crowd newsletter focuses on the evolution and economics of high-technology business and strategy. Read the most recent one at: http://www.benchmark.com/cgi- bin/suid/~bcmlp/newsletter.cgi?mode=display&year=2003 A solid article on 802.11 and Cellular: http://www.benchmark.com/cgi- bin/suid/~bcmlp/newsletter.cgi?mode=show&year=2003&date=2003 -01-06 To subscribe: http://www.benchmark.com/Silicon_Valley/Bill_Gurley.html * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * 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 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * (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 fund 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. 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