Building Financial Projections

1. Building Financial Projections April 8, 2003 Charlie Tillett SM ‘91 508 358-7861 charlietillett@attbi.com

2. Agenda • Part 1 • The Business Model • Part 2 • Building Your Financial Projections

3. Background 1991 MIT Sloan School of Management Spring 1990 Third Place $10K Contest Summer 1990 Intern - Boston Capital Ventures ‘91 to ‘00 CFO of NetScout Systems (NTCT) - VC financings of $6MM and $45MM - IPO in August 1999 ’00 to present Consulting CFO - Dot Com – Magazine Subscriptions - Enterprise Software - Bomb Detection for checked baggage

4. Dividing EquityAmong Founders & Investors

5. Disclaimer - Charlie’s Rules-of-Thumb • Focused on making attractive to investors • Most relevant for technology-based companies • May not apply to your industry or business model • Most Common Business Plan Errors: • Revenue too high in year 4 • Profit too high in year 4

6. What is a Business Model? Boston Globe - January 9, 2003 • StorageNetworks replaced the CEO and eliminated 50% of its workforce as it struggles to find a new business model. • Tried to build a national network of data-storage infrastructure available for lease but was hurt by customer reluctance to let outsiders handle their most sensitive data. • Their new business model is focused on storage management software.

7. The Business Model • A Profit & Loss Statement that details your financial performance in percentage terms • Assumes you reach critical mass • Explains WHY your business will MAKE MONEY • The complete business plan shows HOW!

8. Profit & Loss (P&L) StatementAlso called Income Statement Sample • Revenue (after discounts) • Cost of Goods Sold (COGS) • Direct product cost • Mfg but NOT R&D • Gross Margin or Gross Profit • Departmental Expenses • Operating Profit – Operating Loss • Profit before taxes (PBT) • EBITDA (Earnings before interest, taxes, depreciation, amortization)

9. Business Model Example“Typical” Data Communications Company

10. Actual Business ModelsQ3 ’98 and Q3 ’00

11. Actual Business ModelsQ3 ’98 and Q3 ’00

12. Case Study - CISCO Forecast – December 2002

13. Building YOUR Model • Start with what you “know” • Your Cost of Goods Sold • R&D should end up at 10% to 20% • G&A should end up at 5% to 15% • Target an operating profit of 15% to 20% • Only remaining variable is Sales & Marketing

14. Building YOUR Model • Verify your assumptions by looking at competitors or comparable companies • You must be able to justify that: • You can meet a sales target of $X • With a Sales/Marketing budget of Y% of $X

15. Case Study – Storage Networks

16. Case Study – Storage Networks

17. Case Study – Storage Networks

18. Case Study – Storage Networks R&D plus S&M = 19% Revenue

19. Case Study – Storage Networks R&D plus S&M = 19% Revenue If we assume R&D = $4MM then Revenue = ($4 + S&M) / .19

20. Case Study – Storage Networks

21. Case Study – Storage Networks

22. First Major Decision:How will you sell your product?

23. Building Your Financial ProjectionsRules-of-Thumb for knowledge-based companies • Average employee salary will be $70K to $80K • Employee benefits will add 15% • Initially, salaries will be 60% to 75% of non-COGS expense • Remainder will be rent, utilities, supplies, phones, travel • UNLESS you have extraordinary marketing!!! • Will reduce to 50% to 55% over time • If you know your staffing plan, you can make a good estimate of each department’s expenses

24. Building Your Financial ProjectionsRules-of-Thumb for knowledge-based companies • Sales Projections in year 5 • Between $50MM and $100MM per year • Market Size • Between 5% and 25% • Revenue per Employee • Between $125K and $300K • Revenue per Salesperson • Between $1MM and $3MM

25. Cash Flow ProjectionsHappiness is a positive cash flow • Burn Rate • Your monthly operating loss plus capital expenditures • Cash Flow Projection • Cumulative operating losses excluding depreciation • Plus cumulative capital expenses • To determine the total cash required • Generally you look at your cumulative operating losses plus cumulative capital expenses as of the month that you reach breakeven

26. VC Observations • VCs don’t expect you to spend you own money BUT they expect you to spend money as though it were your own • VCs don’t want their entrepreneurs to starve BUT they want them to be hungry

27. Financial DataPresentation Suggestions • Steady, consistent revenue growth • No hockey sticks • Steady, consistent evolution of your model • Show % next to quarterly & yearly columns • Show pre-tax only • Don’t allocate G&A expenses • Show depreciation expenses on a separate line

28. Executive SummaryPresentation Suggestions • Annual P&L for 4 or 5 years (with %) • Data to justify revenue projections • Unit sales • Average selling price (ASP) • What quarter you will be profitable • Your total cash requirement

29. Full Business PlanPresentation Suggestions • Page 1: Annual P&L for 4 years • Page 2 & 3: Quarterly P&L for all 4 years • Page 4: Quarterly Staffing plan for 4 years • Page 5: Quarterly cash flow for 4 years

30. End Result - Profit and Loss Statement

31. Profit and Loss Statement – Quarterly

32. Sales and COGS Forecast

33. Staffing Plan

34. Salary Expenses

35. Non-Salary Expenses

36. Non-Salary Expenses

37. Profit and Loss Statement - Quarterly

38. CAPEX & Cash Flow Projection

39. Real World Expenses • See $50K Web Site for more detail

40. PART 2 - Dividing the Pie • Address two fundamental questions: • How much of my company should the VCs get? • How much of my company should employees get? • “The Formula” • Conceptual Framework for Stock Ownership • Some Real-World Examples & Advice

41. Valuation – “The Formula”VC % = VC$ / (pre-money + VC$) VC Ownership % assumes only 1 round of financing

42. YourCompany.COM Stage 1 - Before any funding (pre-money) Let’s assume a pre-money value of $10MM

43. YourCompany.COM Stage 2 – Assume $10MM raised at a $10MM pre-money valuation would yield a post-money valuation of $20MM) The WRONG* way to look at it: * WRONG because the post-money pie is shown as the same size as the pre-money pie

44. YourCompany.COM Stage 2 – Same example The RIGHT way to look at it Original Company ($10MM Pre-Money) $10MM Cash in Bank (Money)

45. YourCompany.COM Stage 2 – Same example Combine the two and the “post-money” pie is twice as large Pie represents both “original company” and new cash

46. YourCompany.COM Stage 2 – Another way to look at the same example. Your holdings are the same but the company is twice as large Founder VC Employees Think of issuing stock to employees in the same way

47. Raising money in stages

48. Some Observations on VCs • What do VCs want? Return on investment of: • Three to five times (300%-500%) • Within 4 to 6 years • Therefore: • Your company’s post-money value must increase 3 to 5 times • Prefer management with a track record • Average investment is $5+ million • By the liquidity event, VCs want to make sure that founders hold at least 10% to 20% of the equity • Round 1 financings are in the range of 25% to 50% • This allows for additional dilution in round 2 & 3 • They will also build in an option pool of 10% to 20%

49. Employee Equity – Real World Examples • Create the right number of shares – 10MM to 20MM • Equity by Position – very general guidelines • CEO – 5% to 10% • Other VPs – 1% to 2.5% • First Level Managers - .2% to .3% • Scale down other levels of employees from here • Slight premium for technical hires • Early stage companies may have to exceed these guidelines • 4 year vesting, 25% after 1 year then 6.25% per quarter

50. VC Funding Recommendations • Create more VC interest to increase the valuation • Research VC Firms. Approach one appropriate for: • Your business stage • Your business size • Your industry • There’s more than valuation: • Advice & council • How will they react when things go bad?