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Crunching the numbers
§ Prospective investors are mainly interested in the bottom
line
– What profits and cash flows will the business generate?
– What is my required return?
– How much of the business do I need to own?
– What is my exit strategy?
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Successful Venture Life Cycle
Stages of a successful venture’s life from development
through various stages of revenue growth
1. Development Stage:
– period involving the progression from an idea to a promising
business opportunity
2. Startup Stage:
– period when the venture is organized, developed, and an initial
revenue model is put in place
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Successful Venture Life Cycle
3. Survival Stage:
– period when revenues start to grow and help pay some, but
typically not all, of the expenses
4. Rapid-Growth Stage:
– period of very rapid revenue and cash flow growth
5. Maturity Stage:
– period when the growth of revenue and cash flow continues but at
a much slower rate than in the rapid-growth stage
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Business Angels
§ Angel investors invest in start-ups. The capital angel
investors provide may be a one-time investment to help
the business propel or an ongoing injection of money to
support and carry the company through its difficult early
stages.
§ Examples:
– http://melbourneangels.net/
– http://scaleinvestors.com.au/
– This program
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Venture Capital
§ Venture capital is financing that investors provide to start-
up companies and small businesses that are believed to
have long term growth potential. For startups venture
capital is an essential source of money. Risk is typically
high for investors, and VC investors usually get a say in
company decisions.
§ Typically manage a portfolio of start-up investments
§ Examples:
– http://www.acorncapital.com.au/
– http://www.starfishvc.com/
– http://contango.com.au/
– https://www.trimantium.com/
–
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Finance principles for start-ups
1. Real, Human, and Financial Capital Must be Rented
from Owners
2. Risk and Expected Reward Go Hand in Hand
3. While Accounting is the Language of Business, Cash is
the Currency
New Venture Financing Involves Search, Negotiation,
and Privacy
4. A Venture’s Financial Objective is to Increase Value
5. It is Dangerous to Assume that People Act Against Their
Own Self-Interest
6. Venture Character and Reputation Can be Assets or
Liabilities
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The bottom line
§ Start-ups are usually:
– Burning cash
– Not making profits in the short term
– Takes time to break even
§ Why invest?
– Long term prospects for growth
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Cash Burn and Cash Build
§ Cash Burn:
– cash a venture expends on its operating and financing expenses
and its investments in assets
§ Cash Burn Rate:
– cash burn for a fixed period of time, typically a month
§ Cash Burn = Inventory-related expenses + Admin
expenses + Marketing expenses + R& D expense +
Interest expenses + Change in prepaid expenses –
(Change in accrued liabilities + Change in payables) +
Capital investment + Taxes
§ Cash Build = Net sales – Change in receivables
§ Cash Build Rate:
– Cash build for a fixed period of time, typically a month
§ Net Cash Burn = Cash burn - Cash build
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Forecasting
§ Need to forecast sales, variable costs and fixed costs
over, say, 5 to 7 years, until business is at rapid growth or
(preferably) maturity stage
§ Also include development costs.
§ Expect negative cash flows for the first few years
§ See my Softtec example
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Operating leverage
§ Operating leverage is a measure of how revenue growth
translates into growth in operating income
§ It depends on sales and costs
– In particular, fixed versus variable costs
§ If variable costs are low, profit varies more with sales.
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Austral Carbonlite Inc. Versus Fiberspeed
Carbonlite Inc Fiberspeed Corp
Sales volume 10,000 sofas 10,000 sofas
Price $1,000 $1,000
Total Revenue $10,000,000 $10,000,000
Fixed costs per year $5,000,000 $2,000,000
Variable costs per frame $400 $700
Total cost $9,000,000 $9,000,000
EBIT $1,000,000 $1,000,000
11,000 frames11,000 frames
$11,000,000$11,000,000
$9,700,000$9,400,000
$1,300,000$1,600,000
• What if sales volume increases by 10% ?
• Austral Carbonlite’s EBIT increases faster because it has high operating
leverage.
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Valuing Start-ups
§ Valuation is difficult
– High risk that the venture won’t succeed
– Initial negative cash flows
§ Value of a company
– Present value of all cash flows received
– For an investor, it’s all about $
– Assumptions and forecasting
§ Future cash flows
§ Risk
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Venture Capital method
§ VC contributes and investment and has a required return
over investment period.
– For example, $1m for 3 years with a required return of 30%
– Exit value = 1m(1+.3)3 = $2.197m
– They invest $1m with the expectation or receiving $2.197 in the
future.
§ Estimate value at exit
– Typically a multiple of P/E or EBITDA
– In this example, P/E multiple is 10, final earnings E = $0.25m
– Value in 3 years estimated at $2.5m.
§ How much ownership does VC get
– 2.197/2.5 = 88%
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Venture Capital method
§ But staff will need some incentives too
– Grant them 300,000 shares
– Vesting in 3 years
§ If there are 1m shares on issue before the capital
injection, VC gets
– 1m/(1-.88) = 8.25 shares
– Total number of shares = 9.25m shares
§ Staff get 300,000 shares, which is 3.2%
§ Owners keep 700,000 shares, which is 7.6%
– Ownership diluted!
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Example
§ A venture capitalist firm wants to invest $1.5 million in
your NYDeli dot.com venture that you started six months
ago. You do not expect to make a profit until year four
when your net income is expected to be $3 million. The
shares of BioSystems, a “comparable” firm, currently
trade in the over-the-counter market at $30 per share.
BioSystems’ net income for the most recent year was
$300,000 and the firm has 150,000 shares of common
stock outstanding.
BFF5905 New Venture Finance
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Example (2)
A. Apply the VC method to determine the value of the
NYDeli at the end of four years.
B. If VCs want a 40% compound annual rate of return on
similar investments, what is the present value of your
NYDeli venture?
C. What percentage of ownership of the NYDeli dot.com
venture will you have to give up to the VC firm for its
$1.5 million investment?
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Example continued
A. Apply the VC method to determine the value of the
NYDeli at the end of four years.
§ Comparable’s EPS = $300,000 / 150,000 = 2
§ Comparable’s P/E = 30/2 = 15
§ Venture’s projected value at year 4 = 15 * 3,000,000 =
45,000,000
BFF5905 New Venture Finance
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Example continued
B. If VCs want a 40% compound annual rate of return on
similar investments, what is the present value of your
NYDeli venture?
§ 45,000,000 / 1.4^4 = 11,713,869
C. What percentage of ownership of the NYDeli dot.com
venture will you have to give up to the VC firm for its $1.5
million investment?
§ 1,500,000 / 11,713,869 = 12.81%
BFF5905 New Venture Finance
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Summary
§ This a very brief overview
§ Need a knowledge of accounting practices and finance
§ It’s all about the cash flows
– Forecasting cash flows
– Understanding the risks
– Knowing where to access funds, depending on your lifecycle
stage.