9 . Financial Models

 COURSE POINTS

• Models are only as good as their inputs — garbage in, garbage out
• Knowing your monthly burn rate allows for better cash flow management
• Start simple. Add complexity when the fundamentals are understood.
• Iterate as required — models should never be static but always baselined
• It’s fine to make guesses. Just make sure to capture as much detail as you can

DISCUSSION

Models are a great way to simulate scenarios. When planning a business, there are lots of “what if’s” that need to be considered. Modeling these “what if’s” with reproducible, systematic models makes justifying your projections easier. This is also true with an established business. Having a solid model allows you to figure out how to grow and keep ahead of your competition. The nice thing about modeling an established business is that you have historical data. This data is invaluable to confirm your model.

BUDGET MODELS

Budgets are always a sore subject. The typical corporate budget cycle is more political maneuvering than the useful exercise it should be. Budgets for a small business or startup make or break the business because there is no place to hide when you have to get paid. No matter if it’s corporate or a small business, the fundamental budgeting process is the same. To get started, all you need is a spreadsheet and some patience (see the Financial Models: Cash Budgets post below for a sample budget spreadsheet).

SALES MODELS

Critical to your business will be your sales model. This, along with the budget, will determine how much money you will need and when you will start to become profitable. Sales models are challenging for a new business since you really have no history to look at. Thankfully, the government does have some useful statistics for established businesses. The North American Industry Classification System (NAICS) is a database of business statistics. This is a good place to start when building your model, especially for small businesses. The most important consideration when modeling your sales is to select clearly defined and measurable metrics other than sales numbers. This step allows you to model your sales pipeline to ensure that your activities are resulting in sales. Some common pre-sales metrics include: Customer visits, formal quotes, purchase orders or contract renewal. Paying attention to these early indicators will make your model a lot better(see the Sales Model post below for a sample sales model spreadsheet).

MANUFACTURING MODELS

Cost of Goods Sold (COGS) is an important part of your business. Incorrectly estimating manufacturing costs and you can severely restrict your cash flow. Modeling manufacturing costs is similar to doing a budget except that you break down each manufacturing step into discreet steps. These steps will then have a yield (number of good parts) associated with that step. The accumulation of the costs, at each step, then forms your total COGS. If you don’t manufacture anything, then you may need to modify yield to spoilage or whatever. Accurate COGS will allow you to determine if you can improve your margins and what to expect over time. Traditionally, as time goes one and volume goes up, COGS go down. Making an estimate of these variables will set the overall cost improvement goals for your company.

COMPANY VALUATION MODELS

Company evaluations can be a black art. There are several factors that can contribute to what a company is really worth. Modeling this requires having a firm grasp of your present and future sales as well as what other similar companies might be worth. These other companies are called “comps” or compatibles. Researching these comps can sometimes prove problematic, if the companies are private. For private companies that are venture funded, you can usually dig up a press release that says how much was invested in which round. Armed with that data, you can then make some estimates. Once you have done some research, then you need to run some models. Some of the most common are:

1. 1x Revenue: The classic company evaluation if it’s a traditional “brick and mortar” type small business. Usually, you use this one for established businesses with not a lot of growth. Industry norms typically set the multiple. You do see higher and lower multiples of 1x revenue but it all depends on the business and growth rates.
2. Investment In: As a baseline, a company is usually worth the money put in. Now, this depends a lot on the market dynamics at the time and what the company has in terms of IP. In general, this should be the base of your value. In particularly bad markets, your valuation could fluctuate wildly and may drop below investment in.
3. Market Share (and Growth): If your company has a dominate position in a particular market, then your market share is a good indicator of what the company is worth. If the market is growing, then that growth rate can be used to determine your future earnings.
4. Comparable Company Exit: Looking at recent company exists (either going public or being bought) is a good way to gauge the worth of your company. Ideally, the company is in your industry, doing your exact business. The farther afield, the harder the argument is for the comparison.
5. Internal Rate of Return (IIR): Is the percent growth of an investment over a predetermine period of time. IIR takes into account investment and cash flows from the project. Venture Capitalists (VCs) like to use this model because it takes into account the investments over time and the exit at the end. The percent they like to see is what would give them 10x in 3-5 years. The IIR to do that is north of 75%.
6. 10x Investment In: When a VC looks at a company, they have a specific model in mind for how much the company needs to be worth. This means that your exit in 3-5 years needs to be 10x the investment in. As you look at your sales model, keep this in mind. If your company cannot achieve this then investment via VC will be almost impossible.

In reality, the value of your company is really what someone is willing to pay. In that respect, company evaluations can be subjective. It’s still a good idea to have a good estimate of what your company might be worth. You never know when someone might want to buy it or when you might need to go raise money.

THE PREVERBAL GARBAGE IN, GARBAGE OUT

Models are only as good as their inputs. Bad data or poorly constructed models will just give you rotten results. When modeling, it’s always a good idea to see if different models give you the same (or roughly the same) answers. This double check will make your model a lot better and more believable. The common way to do this is a bottoms up, followed by tops down analysis. Bottoms up analysis builds the model from directly known data (like your sales numbers or manufacturing costs). It then builds the desired result. A tops down model takes the broad data (like total market, market share or economic growth) and builds the model moving down toward the details (like required monthly sales and COGS). Good models then mix both to cross check assumptions.

THINGS TO DO

1. List your household expenses per month (your burn rate). What is your biggest expense? How about your least? If you wanted to reduce your burn rate by 10%, what would you do? List your income. Do you increase or dec
2. If you have a business or plan on starting one, do the same as 1. How does it compare to your household expenses?
3. Take your favorite company. Do a simple model for their sales by making assumptions about their business. Now, check their sales. How far off are you from what they really do? What do you think you should change in your model to make it more accurate.
4. Break down a manufacturing process into sub-processes. Assign a cost and yield to each. What is the overall cost compared to actual? Why do you think it’s different?
5. Evaluate a company by researching similar companies. Look at public companies and similar companies that got bought. What range of values did you find?