Creating a simple financial model of your startup

For what

My friend who is looking for funding for IT start-ups often complains that people who come up with an idea cannot even roughly tell or appreciate the financial component of their project. This is quite logical, given that even the fundamentals of finance in Russian universities are usually not taught in any department except management and economics. In this article I want to briefly tell you about the most basic principles for creating a simple financial model. I hope this information will help many colleagues - entrepreneurs in evaluating ideas for the implementation and preparation of presentations for investors.

Briefly about yourself. Studying at the faculty of the UMC MSU, before the fourth year I had only a vague idea about finances. Later, after working 3 years in consulting and a third of this time - working on purchase transactions of companies, during which they had to create financial models for assessing their value, knowledge about finances increased. At once I will make a reservation that in this article the basic things are written and many subtleties that need to be taken into account if you conduct a detailed assessment of the company's value are not affected. Nevertheless, I hope that knowledge in this (and the maximum - the next article - continuation) will be enough for having a non-financial education to draw up a business plan for your project. In the comments to the article I will be glad to answer any questions.

I.Pro value of money, the cost of companies and tea with sweets

One of the most basic principles of finance - the ruble today is worth more than the ruble tomorrow. After all, the ruble today you can put in the bank and earn interest on it tomorrow. Suppose it is 10%. In this case, for you now the ruble is the same as 1 ruble 10 kopecks in a year, because if you have a ruble today, then you can put it in the bank and get 1 ruble 10 kopecks in a year. (The rule is valid in the opposite direction - you can borrow a ruble now and give more in a year).
')
The second principle is that there is a direct relationship between risk and investor's expected return. Why, for example, does Sberbank offer investors lower interest rates than a small regional bank? Because investing money in a small regional bank, you are more likely to lose them, and therefore the bank has to offer greater profitability in order to attract your investments - savings.
Therefore, for the example in the first paragraph, the key point is that 1 ruble is equivalent to 1 ruble to 10 kopecks at this risk level. If the risk of investment changes, then 1 ruble will cost differently in the future.

Now all together:
How much are you willing to pay for a company that will require you to invest an additional 1 million rubles after the purchase, and then bring the same income for this million a year, what would you have if you put a million in a small investment company with the same level of risk?

You would not be willing to pay a single ruble. Why pay, if you can bring a million to an investment company just to get the same income with the same level of risk, and you will be given tea with sweets when opening a deposit.

Now, if the company brought more income than any other alternative with the same level of risk, then you would be ready to pay something for it in addition to the million that you will need to invest further. A company that makes such magic is worth something. The company's value for you at the current time is called NPV (Net Present Value) and in view of the above, it is calculated as:



Having the value of cash flows and the discount rate (it is the cost of capital, it is WACC, it is in the picture above - r) - we can estimate its value. Evaluating the WACC “by all rules” requires deeper knowledge of corporate finance. In some cases, the investor will ask you to calculate the value at a certain rate, which he will indicate.
An alternative option is to find reports of financial analysts for any public companies from your industry and see which WACC they put in their calculations. Next, there are two approaches. Or increase WACC by 3-5%, saying that this is a payment for the additional risk that you have a small startup at the initial stage. A more “scientific” approach is to leave the rate without any extra charges for the risks of an individual company, but to reduce the numerator is cash flow, as there is a possibility that the project will not work. (for those, the cat has studied the likelihood - replace your projections with the mathematical probability of these projections, where there is a nonzero probability that the project will not go and the profit will be 0th). I’ll say at once that the “scientific” approach, in spite of great intuition, in my experience ran into a misunderstanding of many employees of M & A departments of large companies (“And what is your WACC so small? The company is small!”), So you can use the first approach and just increase WACC by 3-5% from WACC of the same mail.ru
The only comment - do not forget to look in the same reports, in what currency are the calculations and discounting and find a report where the currency coincides with yours. WACC depends on the currency in the numerator. Just as in real life, when the income in rubles with the deposit, the bank promises higher than with the deposit in francs. What is the logic? We take the currency with the lowest WACC (at least in dollars), and our NPV automatically turns out more. Not really. In dollars, inflation is lower than in rubles, so the numerator in rubles will also grow more slowly, and these factors must balance out.

So, how do we get the cash flow values ​​for each year that we plan to earn and then discount to get the cherished figure - the value of the company?

Like this:
Free Cash Flow = Revenue - Costs - payment of interest on loans to external lenders - taxes - change in working capital

In this article I will talk about the first two, probably the most important components.
(About the rest - in the next one)

Ii. Revenue. How to evaluate, even if you are 99% likely to be wrong

“All that we know about the revenue forecasts that the team indicates in its business plans when they come to us,” is that they are 100% likely to be wrong. "
Brad Feld, Foundry Group Venture Fund Partner

Even if the forecasts turn out to be wrong, the investor usually expects an understanding from you of the ways to monetize the project and estimate the revenue (of course, he can think it out for you based on his experience and in any case he will make such an assessment, but the inability to answer the basic question: " what you are going to earn and how much "significantly reduces your credibility and bargaining position).

Revenues can be estimated in two ways - “top-down” and “bottom-up” (it is better to make both assessments).
With a top-down assessment, you take an estimate of the entire size of the target market (for example, the total market for corporate cloud solutions was $ X million) and multiply it by your assessment of the market share your company can take. For example, there are 8 main players on the market. Assume that the main players have a share in 80 percent of the market. Then in the most simplified case, you can say that you plan to occupy 80% / 8 = 10% of the market in 5 years. And then the clarifications begin - why will you have a share of more or less (do you have a unique technology protected by a patent? Do the main competitors have exclusive contracts with the main players for 5 years?). Naturally, you will not be able to determine at the beginning of the idea what proportion, up to a percent, you can take. But even a rough estimate will give an understanding of the order of the numbers - how attractive the project is. In addition, you can always count on the contrary - what market share you need to get in order to discourage the investments you requested and provide investors with a certain level of profitability.
Naturally, you are laying and increasing the size of the market. But here it is important to understand - due to what the market is growing. If analysts expect a doubling of the market due to the emergence of 10 new players who will spend a lot of money on educating clients about the culture of using cloud solutions, you need to reduce your forecasts for the market share in this larger market.

When estimating from the bottom up, you multiply the average profit per user / client by their expected number (i.e., not from the larger (market), but from private buyers). If your monetization model implies a monthly fee, then you will take the weighted average monthly fee (for example, 90% x base rate + 10% x premium).

Try to make both assessments and see how they converge.
It is interesting to check, fixing the estimate from above and profit per subscriber, how many subscribers this estimate from above assumes. You can check and estimate from above - by fixing the size of the market to calculate what market share implies the planned number of subscribers. Adjust the parameters so that the estimates converge. (It is better to correct the parameters in which you are sure of the least).

Iii. Costs

As a rule, the main items of expenditure are: wages, marketing and advertising, technical costs (equipment rental, traffic and server placement fees), rental of premises (office, warehouses?), Purchase of equipment and software

Expenses are divided according to the reporting of operating and capital. If in a nutshell: capital is an investment in some fixed assets, for example, equipment. Operational - the cost of daily activities. The main difference lies in the different effects when accounting for taxes, but to build a simple business plan, we still ignore this and wake up count all costs as if they were operational. (I will try to cover the subject of taxes in more detail in the next article)

Most of the costs are fairly easy to estimate, calling around landlords, walking through recruitment sites, server hosting companies.

In respect of personnel, according to Russian law, personnel costs are subject to the Unified Social Tax (26%), so multiply the salary of employees by 1.4 (an additional 14% is a buffer for any other expenses like phone, office and coffee)

For the rest of the costs, apart from the promotion, there are no difficulties - we call round the suppliers and google prices on the Internet. The main thing is not to forget that many costs are not fixed (for example, rental of containers / number of call center employees) and depend on the number of subscribers. Therefore, if you further test different scenarios for the number of users, consider changing costs as a function of the number of the same subscribers in order not to get too optimistic forecasts.

More difficult to estimate the cost of marketing and promotion.
Since in each industry and even a niche within the industry the costs of attracting one new customer can vary greatly, it’s difficult to give general advice. As in the case of our project Netflip.ru, I will advise you to consult with friends (or strangers :)) experts involved in promotion.
Ideally, it is worthwhile to paint possible promotion options, evaluate the conversion of visitors for each, the cost of attracting one visitor (for example, call the magazine and find out how much publication of an article or advertisement costs, then estimate attendance and circulation, and then the probability of conversion). To promote through Yandex.direct or Google.adwords, both services provide free tools for estimating the cost of a click on various keywords.

And do not forget in the numerator and in the denominator to introduce growth associated with inflation. Speaking of inflation. Her forecasts, as well as exchange rate forecasts, can be found on eiu.com - a reputable source used by all investment analysts. (No, “respected” - it does not mean that the forecasts come true. Moreover, in my three years of experience, the exchange rate forecasts changed once in different directions every three to five months. But you need to say something when an investor asks you where does your currency forecast come from)

In the next article I will talk about taxes, changes in working capital, how to bring everything together and try to give very practical advice on how the evaluation process goes in practice.