Building Financial Projections April 8, 2003 Charlie Tillett SM ‘91 508 358-7861 [email_address]

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

Part 1

The Business Model

Part 2

Building Your Financial Projections

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

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

Dividing Equity Among Founders & Investors

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

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

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.

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.

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!

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!

Profit & Loss (P&L) Statement Also called Income Statement 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) 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)

Business Model Example “Typical” Data Communications Company

Actual Business Models Q3 ’98 and Q3 ’00

Actual Business Models Q3 ’98 and Q3 ’00

Case Study - CISCO F orecast – December 2002

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

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

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

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

Case Study – Storage Networks

Case Study – Storage Networks

Case Study – Storage Networks

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

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

Case Study – Storage Networks

Case Study – Storage Networks

First Major Decision: How will you sell your product?

Building Your Financial Projections Rules-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

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

Building Your Financial Projections Rules-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

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

Cash Flow Projections Happiness 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

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

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

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

Financial Data Presentation 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

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

Executive Summary Presentation 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

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

Full Business Plan Presentation 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

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

End Result - Profit and Loss Statement

Profit and Loss Statement – Quarterly

Sales and COGS Forecast

Staffing Plan

Salary Expenses

Non-Salary Expenses

Non-Salary Expenses

Profit and Loss Statement - Quarterly

CAPEX & Cash Flow Projection

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

See $50K Web Site for more detail

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

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

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

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

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

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

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

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

Raising money in stages

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%

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%

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

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

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?

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?

Random Advice Build a GREAT team Technology, Marketing. Sales, Finance Get a good lawyer before you: Negotiate with VCs Grant stock or options A Big-5 accountant adds to your credibility Write this down – Section 83(b) of IRS tax code Build relationships with investment community (VCs & investment bankers) BEFORE you need them

Build a GREAT team

Technology, Marketing. Sales, Finance

Get a good lawyer before you:

Negotiate with VCs

Grant stock or options

A Big-5 accountant adds to your credibility

Write this down – Section 83(b) of IRS tax code

Build relationships with investment community (VCs & investment bankers) BEFORE you need them