Financial Model Critique: Startup Funding

July 14, 2008 by financialmodel

The Redfin real estate financial model posted by Guy Kawasaki assumes a worst case scenario and bases all its assumptions and financial statements on that. The model presents artificially low financial projections, which may not be realistic but will ensure that the startup gets additional funding easily. The purpose, as Glenn Kelman says, is to be able to say the three magical words “we outperformed projections” and guarantee a constant flow of funds to continue operations. If, on the other hand, the financial model had been realistic enough to include higher projections, the out-performance would have been missing, leading to difficulties in raising more funds. This would eventually result in a liquidity crunch for the startup.

Financial model planners in this case are focusing on what drives venture capitalists to invest in a startup. Most venture capital firms aim to generate tenfold returns in five to seven years and, thus, invest in businesses that have the potential to outperform. But is it that simple? Can investors be easily manipulated into believing something? Do they really invest their money on the expectations of a startup outperforming the worst of projections? Most venture capitalists and investors are smart enough to know where to put their funds and what returns can be generated.  Most savvy investors looking to fund  startups discount the startup financial projections and assume a worst case scenario.

Although it is appropriate to be pessimistic in terms of revenue recognition while assuming the highest cost scenario, venture capitalists also take into account the chances of the worst case scenario actually happening. Financial models are based on assumptions that create most of the variation between the actual figures and the projections made in a financial model. In this case, the actual figures reveal that, despite the conservative approach adopted by the Redfin real estate financial model, some of the costs, such as the rent per employee per month, the annual payroll increase, monthly travel and telephone costs per employee, were higher than the estimated levels.

The Redfin real estate financial projections also suggests that the assumption of economies of scale is not correct. Financial model planners should bear in mind that the bigger the business, the higher are the per employee costs, which is somewhat counterintuitive. Moreover, Redfin suggests that financial model planners should not take it for granted that the startup’s product will sell. Instead they should base their revenue projections on “if the product sells.”  As Redfin puts it, a financial model should provide the startup adequate time to grow without hoping for too much.

And it is of utmost importance for a startup to outline the assumptions of the financial model clearly, so that investors have no doubt about the message being conveyed.

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The Franchise Financial Model

July 14, 2008 by financialmodel

Modeling financial projections for a franchise is not an easy task, keeping in view the complex relationships between a franchisor, a master franchisee and a unit franchise. Moreover, the flexibility to make temporary or permanent changes to selling prices or to altering the product, merchandise or service mix is generally missing in the case of a franchise opportunity.

Once an agreement related to the franchise fees has been locked into the franchise’s financial projections, royalty charges and other fees has been established, the possibility of adjustments is limited. A franchisor can only modify the   terms in the case of future franchise opportunities, at the time of the franchise renewal or after a long period of negotiation. Similarly, the services provided by a franchisor to his franchisees are predetermined and can not be modified easily.

Financial modeling for franchisors requires an analysis of the franchise business dynamics, the existing revenues being generated, forecasted financial projections, the examination of services being provided by a franchisor to the franchisees and the study of service and other system costs. In addition, an analysis of the financial and capital requirements of a business and the determination of an acceptable IRR (internal rate of return) are also essential.

The first step in developing a franchise financial projections model is to reach an agreement regarding the royalty fee levels that ensures adequate profitability for both the franchisor and the franchisee. The amount of the fees will vary for a new franchise, which requires more services from the franchisor, from that of a franchise running mature operations and requiring lesser services. Again, the number and the nature of the markets being catered to by a franchise are important in determining the fees. Similarly, the financial model must reflect that the multi-unit franchisees offer the franchisor certain efficiencies that are not present in single unit operators and are, therefore, less expensive to service.

Financial modeling involves a review of the financial and marketing services being offered by the franchisor and the segregation of costs into initial or continuous. The next step is the calculation of the rate of royalty and the establishment of retail, advertising and promotional expenditure or fees.

Project finance modeling for business franchise should include all the usual financial statements, such as the cash flow statement, profit and loss statements, balance sheets, ROI and payback statements, apart from a table detailing the startup capital costs and another table detailing the various assumptions made for the calculation of estimated revenues, costs and other financials. Details regarding the number of franchisees and the areas in which they are operating should also form a part of business financial forecasting.

Need financial model help?  Contact www.FinanicalModel.net for a free consultation!  Our expert consultants will help to devise custom financial projections for your business.

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Real Estate Financial Model Series: Real Estate Development Costs – Hard and Soft

July 11, 2008 by financialmodel

So you want to be a developer? Big or small, commercial or residential, there are many real estate development opportunities out there. And depending on where ‘there’ is for you, the development costs will vary greatly compared to other parts of the world. Preparing real estate development financial models will hopefully cause you to think about all the costs involved.

As varied as the costs are, in the real estate development game, there is one certainty – there will be costs and those costs can be broken down into two categories – hard and soft. So, it makes sense then to break them out separately and subtotal them in your real estate development financial model.

Then what goes where?

As precisely as the name implies, think of hard costs as the actual physical construction cost of the development – in other words, costs applied to surveying, staking the building, grading the site, pouring the footers, erecting the walls, and so on, and so on. The cost of the labor, material, equipment rental, rubbish removal, port-a-john rental, etc. that go into the finished product – whether a building, a park, or golf course – are all considered hard costs.

On the other hand, soft costs cover – for the most part – those services that will get you to the point of construction. Soft costs are typically those things for which the finished product is on paper. You guessed it; engineering, architecture, development agreements (legal), permits, environmental impact surveys, boundary and topographic surveys, etc.

Those are a few soft costs for services that will get you to the point of breaking ground.

Don’t forget though in your financial model to include place holders for those soft costs that will occur during and after construction. Depending on the scope and scale of your real estate development project, you may need periodic reviews by the architect and/or engineer. Too, soft costs can also include third party testing agencies for inspections of such things as soil compactions, concrete strength, structural welds, application of fireproofing material, etc. to name a few.

FinancialModel.net is eager to help you model your real estate development project. For help with your real estate financial model – please contact us at info@financialmodel.net.

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What Angel Investors Want

July 8, 2008 by financialmodel

While angel investors invest mostly in early-stage companies, their contribution to the business community is not small by any standards. In 2007, venture capitalists invested $29.4 billion in 3,813 companies. In the same period, angel investors invested $26 billion in 57,120 companies, according to the University of New Hampshire’s Center for Venture Research.

In order to be able to attract some of these funds, you need to understand what angel investors really want. International angel investors are quick to reject a number of the investment proposals that come their way. So, what kind of financial projections and business model are the things that secure the investment?

Be it as capital for startup or small business financing, angel investors want to back an enterprise that is “investor-ready.” Most angel investors like to be vested with managerial capacity in developing an enterprise. This endows angel investors with the power to be in a Herculean, claque-like position vis-à-vis the Board of Directors.

A key factor that an angel investor looks for is solid return on investment (IRR). Be it capital for startup or business startup money, active angel investors ride high on the thrill to build and finally create a thriving business model. The appropriate formulaic expectation of most angel investors would be to take out seven dollars for each dollar that’s invested into a company in the following seven years.

An essential factor that would help one to find an angel investor and retain interest is by proving competency and credibility in terms of a complete team. From an investor’s viewpoint, the prerequisite for a thriving business model would be the presence of a complete management team. This typically comprises a highly skilled and knowledgeable pool of people with expertise and experience in leading the business to the next level.

Further, active angel investors attach significant importance to a well structured, comprehensive, detailed business plan financial model. Such a business plan is typically based on accurate financial projections, financial modeling, and detailed marketing plans. The specifics about the proposed market and the capital for startup need to be elucidated. The detailing would be about the preparation for how to reach higher levels, step by step.

For most angel investors, a minority equity ownership option is a highly appreciated choice. Therefore, an entrepreneur’s proposed business should be structured to facilitate investment.Lastly, most angel investors expect to get a formal shareholder’s agreement and a viable exit strategy. Where angel investors have equity ownership in the business, the most preferred exit strategy would be sale of the company’s shares to its principals. For debt-holding angel investors, sale or even merger of the company may be a preferred option.

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How Thorough Do My Startup’s Financial Projections Need to Be?

July 8, 2008 by financialmodel

Startups should always make business plan financial projections before they begin operations. Startups realize the need to build a financial model outlining the expected costs and anticipated revenues from their businesses. This offers an excellent opportunity to distinguish between a good business and a bad business. But some of the questions that will arise in your mind are… How detailed and thorough should this financial model should be? Should it be customized or standardized?

Drawing up financial projections and making a financial model will also provide you an opportunity to identify the financial needs of your business and assist you immensely in working out the funding details. The details outlined in a business plan financial model, however, need to be constantly updated and reworked according to the progress of various projects and with any change in the assumptions on which it was based.

Financial analysis needs to be thorough and detailed enough to provide the current value and projected performance of the startup. A financial model should be established after considering the latest industry scenario, the challenges facing the startup and the opportunities available to it. The model should be prepared after a thorough understanding of the industry’s working, the existing players and their performances. However, the lack of information about the business and trends often poses a problem for financial model planners.

The nature of the business of the startup is a key determinant of the type of financial models to be built. In the case of a small business, such as a printing press, the financial model just requires outlining the printing costs, overhead costs, distribution costs and expected revenue schedules after considering payment lag periods. However, in the case of a bigger organization, having multiple business lines, financial planning is more difficult with more detailed statements required. Financial model planners need to consider the various business lines, the assumptions on which they are going to operate and the market trends impacting the performance of each one of these business lines. So, the standardization of financial models is not recommended in this case.

Now, effective financial planning calls for the consideration of all possible factors affecting a company’s financial ratios or projections. Moreover, the assumptions need to be realistic. Similarly, the use of certain fundamental accounting principles to establish figures related to cash flows and the balance sheet is vital for developing a realistic and thorough financial model.

A thorough financial analysis requires proper understanding of the business and, thus, provides the entrepreneur adequate insight into the problems or the situations likely to be faced. While developing a financial model for a start up, it is safe to assume that you are not going to find any support for your products and services and that you will have to work hard to make your business work.

So a financial model for a startup should be thorough enough to provide an idea of whether it is a good or bad venture. The financial projections should also be realistic enough to ensure that the startup is able to survive even in the absence of any support from existing players. However, it is difficult to establish a standardized model for startup businesses because of the varied assumptions, drivers and revenue lines involved. The key to building an effective financial model for startups lies in reaching a workable compromise between the power of detail and that of standardization.

Need help developing your financial projections? Visit www.FinancialModel.net for a free consultation with a model expert.

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Key Considerations for Building a Financial Model for a Rental Property Purchase

July 2, 2008 by financialmodel

As the real estate market continues to throw curve balls in many regions, a lot of new real estate investors are beginning to eye the opportunities that may exist. And you may be one of those people. The key is to make the appropriate assumptions in your rental property financial model.

So, like any new investment opportunity, do good research and try and play out a realistic financial scenario before you go too far with a rental property purchase. Doing so, you’ll be able to get a pretty good indication of whether the investment is worth your time and money, or not.

To be realistic, remember a few key points when doing your rental property financial model. First, even though a property may be fully rented when you look at it, your financial projections must plan for vacancies. Markets will vary greatly, but consider a minimum cost of at least a 5% vacancy rate. Say the vacancies don’t occur this year - then start to tuck away the savings into a long-term contingency or emergency reserve because that 0% vacancy this year may quickly turn into a 10% vacancy next year, or the year after – build your safety net into your financial model.

Second, inventory the property’s physical features to get an idea of the remaining life of such items as the roof, heating and cooling equipment, windows, etc. A reputable home inspector can help provide you with a great deal of insight with regard to the replacement timeframe and rough budgetary amount to use in your financial model if necessary.

Lastly, don’t forget the things you can’t see. And plan for them. A well-thought replacement reserve will help you pay for the longer-term items that will eventually need to be replaced plus those little surprises that come along when you least expect it. Owning real estate always comes with surprises, whether it is an unintended vacancy due to a flakey tenant, a fluke accident, or any number of other real estate related problems. And just because you have property insurance doesn’t necessarily mean that it will cover those little surprises. They can add up fast and setting up the means early to draw from will help lessen the pain if, and when, they occur.

Remember to be realistic and expect the unexpected. This is always a good rule of thumb in any financial model.

Need help developing your financial projections? Visit www.FinancialModel.net for a free consultation with a model expert.

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Financial Model for a Telecom Service Provider (cable, voice and data)

June 28, 2008 by financialmodel

One of the major trends in telecom today is “triple play” in which one provider offers a package deal for voice, broadband Internet and television services in a bid to increase revenues and improve market positioning. Considered to be an opportunity to reap huge profits, the bundling of these services has become more of a necessity to remain competitive and stay in business, according to a report by Pyramid Research. The triple play business is a complex one, with lots of intricacies involved. So a financial model for a telecom service provider offering the full package of services needs to consider the various complexities involved.

Any startup needs to develop a realistic and thorough financial model for presentation to a venture capital, hedge fund or private equity fund in order to raise any type of financing. Financial model specialists developing a financial model for any startup, including a triple play telecom business, should aim to demonstrate the size of the market opportunity, to explain the business model, to show the path to profitability, to quantify the investment needs and to facilitate the valuation of the business.

In the case of a triple play telecom service business, financial model planners need to remember and take into account that while the bundling of services increases average revenue per user (ARPU) and is a key factor in reducing churn, the margins in this business are likely to be slimmer than that earned in single play offerings. Telcos need to offer the combined package at a price that is lower than the total of each service would be individually. And the quality of service will have to be at least as good as, if not better than, the services offered by single-play competitors. This is bound to result in the elimination of a number of smaller companies that don’t have the dollars to compete in that sort of an environment.

The assumptions for developing a financial model for triple play businesses should take into account that a triple play offering does not necessarily increase broadband market share and may decrease margins as telcos bid for premium content. The financial statements and financial ratios involved in a model should be based on these facts.

An appropriate financial model for a triple play telecom business should constitute the following financial statements:

  • The statement outlining sources and uses of funds
  • Assumptions made during the preparation of a profit and loss account and a balance sheet
  • Cash flow statement
  • Operating expense detail and the headcount plan

Need help developing your financial projections? Visit www.FinancialModel.net for a free consultation with a model expert.

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Financial Models and the Catwalk

June 19, 2008 by financialmodel

As different as fashion models are on the runway, so are financial models in the realm of business planning – one size does not fit all.  In fact, even within different industries, financial models will vary depending on the specific structures of different businesses; not to mention, the customized elements based on the owners’ knowledge of their revenue streams and costs.

Now back to the analogy.  Sure fashion models are mostly (or, as it may seem anyway) tall, slender, attractive, and exude confidence.  But, they all cannot be expected to wear the same type of fashion with the same effectiveness – some wear swimsuits better than others, some evening gowns, some casual wear – you get the idea.  And picking the right fashion for the right model, or vice versa, can mean lots of orders for a particular clothing line, or even catapulting a model to super status.

How does this all relate to your financial model?  Well, obviously, do not use a retail financial model for a real estate development business, or a web-based business financial model for a restaurant business.  But, more than that, try and look at your proposed business from many different angles to get the right fit.  And, expect to do a bit of hemming, taking-in, or letting-out in order to get it just right.

Along the way, you will have gone through a very deliberate and well-thought process to uncover potential costs you may not have thought of, or even better yet, other potential revenue streams.

But don’t stop with your own perspective.  Ask friends, colleagues, or financial advisors, “What am I not thinking of?” and “Does this financial model accurately reflect my proposed business?”  Doing so will give you more confidence that you’ve tried to uncover all your costs, that you have realistic expectations for revenue, and that your financial model represents the best fit for your business.

The approach will surely help to prepare you for the catwalk as you unveil your business plan to potential investors and financiers.

Need help developing your financial projections?  Visit www.FinancialModel.net for a free consultation with a model expert.

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Welcome to the FinancialModel.net Blog!

March 10, 2008 by financialmodel

This is the first post of the FinancialModel.net blog. This blog is meant to provide greater insight into our approach to financial modeling, and to discuss some of the issues peculiar to modeling companies in different industries and stages of growth. Different approaches to valuation are required for startup, pre-revenue internet companies, mature manufacturing business, and “green field” real estate development projects.

Generally, this blog will touch on four themes:

  1. What Investors Want to See in Financial Models. Most of the models we develop are geared toward startup companies looking to raise capital. Our principals have venture capital experience, and thus will weigh in on what investors expect to see when analyzing financial models. However, we want to stress that financial projections they are just as critical (if not more so) to existing businesses that need to make decisions about projects to invest in.
  1. Exploring the requirements of projections for a variety of industries. For example, real estate financial model’s often involved phased development projects, and can have very specific accounting treatment of revenue and expense recognition rules.
  1. Financial Modeling Techniques and Tips. This blog is also geared toward financial modelers who are looking to hone their skill-set. We will discuss our approach to building models that offer the ability to drill up and down, and that have built-in alerts and checks to ensure that calculations flow through properly.
  1. Resources and Downloads. We will post links to other financial models that we are impressed with, as well as any tools that are of use in the financial modeling process. We will also post some of the models that we develop from time to time.

We will do our best to answer all questions and feedback from our readers.

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