Creating a simple financial model for your startup

For what

A friend of mine who seeks financing for IT startups often complains that people who come up with an idea cannot even tell or evaluate the financial component of their project. This is quite logical, given that even the basics of finance at Russian universities are usually not taught at any faculty other than management and economics. In this article I want to briefly talk about the most basic principles of drawing up a simple financial model. I hope this information will help many colleagues - entrepreneurs in evaluating ideas for implementation and making a presentation for investors.

Briefly about yourself. Studying at the faculty of the VMK of Moscow State University, until the fourth year I had only vague ideas about finances. In the future, after working for 3 years in consulting and a third of this time - working on transactions for the purchase of companies, during which it was necessary to create financial models for assessing their value, knowledge about finances was increased. I must say right away that basic things are written in this article and many of the subtleties that need to be taken into account if you conduct a detailed assessment of the company's value are not touched. Nevertheless, I hope that the knowledge in this (and the maximum - the next article - continued) will be enough to have 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. About the value of money, the value 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, today you can put the ruble in the bank and earn interest on it tomorrow. Let's say it's 10%. In this case, for you the ruble now is the same as 1 ruble 10 kopecks in a year, because if you have a ruble today, you can put it in the bank and get 1 ruble 10 kopecks in a year. (The rule also applies in the opposite direction - you can borrow the ruble now and give more in a year).

The second principle is that there is a direct correlation between risk and the investor expected return. Why, for example, does Sberbank offer depositors lower interest rates than a small regional bank? Because investing money in a small regional bank, you are more likely to risk losing it, and therefore the bank has to offer greater returns in order to attract your investments - savings.
Therefore, for an example from the first paragraph, the key point is that 1 ruble is equivalent to 1 ruble 10 kopecks at the given risk level. If the risk of investment changes, then 1 ruble will cost differently in the future.

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

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

Now, if a company brought in more income than any other alternative with the same level of risk, then you would be ready to pay for it in addition to the million that you will need to invest further. A company doing such magic is worth something. The value of the company for you at the moment 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. The WACC “by the rules” assessment requires a deeper understanding of corporate finance. In some cases, the investor will ask you to calculate the cost with a certain rate, which he will indicate.
An alternative is to find the reports of financial analysts for any public companies in your industry and see which WACC they put in their calculations. Then there are two approaches. Or increase the WACC by 3-5%, saying that this is a payment for the additional risk that you have a small start-up at the initial stage. A more “scientific” approach is to leave the rate without any premiums for the risks of an individual company, but to reduce the numerator — cash flows, since there is a chance that the project will not work. (for those who have studied ter. probabilities - replace your projections with the mathematical probability of these projections, where there is a non-zero probability that the project will not work and the profit will be 0). I must say right away that the “scientific” approach, despite its great intuitiveness, in my experience ran into a misunderstanding of many M&A employees
The only comment - do not forget to look in the same reports in which currency the calculations and discounts go and find the report where the currency coincides with yours. WACC depends on the currency in the numerator. As in real life, when the income in rubles on a deposit the bank promises higher than on a deposit in francs. What is the logic? We take the currency with the lowest WACC (at least in dollars), and our NPV automatically gets more. Not really. In dollars, inflation is lower than in rubles, so the numerator in rubles will also grow more slowly, and these factors should be balanced.

So, how do we get the amount of cash flow 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 - 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)

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

“All we know about the revenue forecasts that the team indicates in their business plans when they come to us” is that they are 100% likely to be wrong. ”
Brad Feld, partner of the Foundry Group venture fund

Even if the forecasts turn out to be wrong, how As a rule, the investor expects you to understand the ways of monetizing the project and evaluating the proceeds (of course, he can think them out for you based on his experience and, in any case, make such an assessment himself, but the inability to answer the basic question: “what are you going to earn and how much” significantly reduce your credibility and negotiating position).

Income can be estimated in two ways - “top-down” and “bottom-up” (it is better to conduct both assessments).
In 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 estimate of the market share that your company can occupy. For example, there are 8 major players in the market. Assume that the main players have a share of 80 percent of the market. Then in the simplest case you can say that you plan to occupy 80% / 8 = 10% of the market in 5 years. And then clarifications begin - why will you have a larger or smaller share (do you have a unique technology protected by a patent? Do the main competitors have exclusive agreements with the main players for 5 years?). Naturally, you will not be able to determine at the beginning of an idea what proportion you can take up to a percentage. But even a rough estimate will give an understanding of the order of numbers - how attractive the project is.
Naturally, you are laying the growth of the market size. 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 customers about the culture of using cloud solutions, you need to reduce your forecasts for the share occupied in this larger market.

In a bottom-up assessment, you multiply the average profit per user / client by their expected number (that is, you’re not starting from the bigger one (market), but from the private buyer. If your monetization model involves a monthly fee, then as an average profit you take a weighted average monthly fee (for example 90% x base rate + 10% x premium).

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

III. Costs

As a rule, the main expense items are: salaries, marketing and advertising, technical costs (equipment rental, traffic and server hosting costs), premises (office, warehouses?), Equipment and software purchases.

Expenses are divided into operating expenses and capital. In a nutshell: capital is an investment in some fixed assets, for example, equipment. Operating - the cost of daily activities. The main difference is the different impact when accounting for taxes, but for the construction of a simple business plan, we will neglect this for now and wake up for now to consider all costs as if they were operational. (I will try to disclose the topic of taxes in more detail in the next article)

Most of the costs are fairly easy to estimate by phoning landlords, going through recruitment sites, server hosting companies.

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

For the rest of the costs, in addition to promoting difficulties, we phonate suppliers and google prices on the Internet. The main thing to remember is that many costs are not fixed (for example, rental of tanks / number of call center employees) and depend on the number of subscribers. Therefore, if you further test various scenarios by the number of users, consider changing the cost as a function of the number of the same subscribers so as not to get too optimistic forecasts).

It is more difficult to assess the costs of marketing and promotion.
Since in each industry and even in a niche within the industry, the costs of attracting one new client can differ greatly, it is difficult to give general advice. As is the case with our Netflip.ru project, I will advise you to consult with familiar (or unfamiliar :)) promotion experts.
Ideally, it’s worth writing down possible promotion options, evaluating the conversion from visitors for each, the cost of attracting one visitor (for example, call the magazine and find out how much it costs to publish an article or advertisement, then estimate the traffic and circulation, and then the probability of conversion). For promotion 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 to enter the growth associated with inflation in the numerator and in the denominator. Speaking of inflation. Her forecasts, as well as exchange rate forecasts, can be found on eiu.com - a respected source used by all investment analysts. (no, “dear” - does not mean that the forecasts come true. Moreover, in my three years of experience - the forecasts of exchange rates changed once in different directions every three to five months. But you need to say something when the investor asks you, where is your forecast for currencies)

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 assessment process goes in practice.