4. Developing Pro Forma Fin. Statements, Projecting CF

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4. Developing Pro Forma Fin. Statements,
Projecting CFs Profits, Assessing Fin. Needs

• 4.1 Introduction to Pro Forma Financial
  Statements for NVs
• 4.2 Foundation of New Venture Financial Pro
  Formas Projecting Sales and Revenues Methods
• 4.2.1 Type of Business
• 4.2.2 Review of Theory of Demand, the Demand
  Function, Econometric Model of Demand,
  Elasticities
• 4.2.3 New Product Life Cycle Curve Bass Model
  or the S Curve
• 4.2.4 Growth Rate Escalation Method
• 4.2.5 Market Potential and Saturation Method
• 4.2.6 Estimating Expected Revenues from Large,
  Discrete Contracts

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4. Developing Pro Forma Fin. Statements,
Projecting CFs Profits, Assessing Fin. Needs

• 4.3 Projecting Expenses
• 4.4 Links Between Cash Flows, Net Income, and
  Balance Sheets
• 4.5 Assessing Financial Investment Needs
• 4.5 Risk Analysis
• 4.6 Review of Various New Venture Pro Forma
  Financials

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4.1 Introduction to Pro Forma Financial
Statements for NVs

• Pro Forma translated from Latin is for the sake
  of form
• A pro forma financial statement is a hypothetical
  financial statement that is based on a set of
  assumptions
• NV pro formas future year projections based on
  little if any history

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4.1 Introduction to Pro Forma Financial
Statements for NVs

• Uses of a pro forma for the NV
• Way to evaluate how much cash the business is
  likely to require and the CF requirements if the
  business grows at a different rate than expected
• Basis for evaluating and valuating the venture
  and for assessing strategic alternatives
• Required by VCs for evaluating and valuating the
  venture basis for negotiation of pre- and
  post-money valuations
• Used as a benchmark to compare actuals v.
  projections feedback for needed changes in
  direction or abandoning the venture

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4.1 Introduction to Pro Forma Financial
Statements for NVs

• The most important NV pro forma financial
  statement Statement of Cash Flows
• The survival of the venture is based on cash, not
  net income
• Need income statement to develop cash flow
  statement
• NV business plans usually include income and cash
  flow statements, may or may not include balance
  sheet

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4.1 Introduction to Pro Forma Financial
Statements for NVs

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4.2 Foundation of New Venture Financial Pro
Formas Projecting Sales and Revenues Methods

• The revenue forecast is the driver of the pro
  forma financials and many aspects of the BP.
• Total Revenue Price (P) x Sales (Qd)
• Sales and price forecasts drive revenues,
  expenses, and resource needs.
• Risk analysis is highly driven by sales, price
  and revenue projections.

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4.2.1 Types of Business

• Sales, price and revenue projection methods will
  be driven by type of business
• Mass market mass / database marketing
• E.g., Website visitation
• E.g., Retail sales
• Large contract, client driven Relationship
  marketing
• E.g., Consulting
• E.g., Commercial construction
• E.g., Information systems sales and service

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4.2.1 Types of Business

• Sales, price and revenue projection methods will
  be driven by type of business
• Mass market
• Sales projections based on percent market
  saturation
• Product life cycle model such as the Bass model
• May use an econometric model if have a track
  record
• Demand equation from microeconomics

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4.2.1 Types of Business

• Sales, price and revenue projection methods will
  be driven by type of business
• Large contract, client driven
• Sales projections based on the expected value of
  a small number of large, identifiable or generic
  projects / contracts
• Sales and revenues are usually phased-in yet and
  lumpy (large jumps in revenue as projects
  generate revenues
• E.g.s Energy services projects (100k-10m, oil
  rig sales (50m - 100m)
• Price projections based on quantitative value to
  the client and results of negotiations
• Large leads in cash outflow before cash inflows

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4.2.2 Review of Theory of Demand, the Demand
Function, Econometric Model of Demand,
Elasticities

Price
Qd
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4.2.2 Demand Function and Econometric Equation

• Demand Curve
• Qd f(P) cet. par.
• Demand Function
• Qd f(P, Psubs, Advertising , Income, )
• where
• P product price
• Psubs price of substitutes
• Income relevant measure of income, such as
  GDP, national income, average customer
  household income,

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4.2.2 Demand Function and Econometric Equation

• Econometric Equation of Sales
• where
• Pt-1 product price in previous period
• Psubs,t-1 price of substitutes in previous
  period
• Incomet-1 relevant measure of income, such as
  GDP, national income, average customer
  household income, in previous period
• a0, , an regression coefficients
• X1,t-1, , Xn,t-1 other variables that drive
  sales
• et error term
• and expect that a2, a3, a4 are positive and a1
  is negative

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4.2.2 Demand Function and Econometric Equation

• Econometric Equation of Sales
• where the price elasticity of sales (percentage
  change in sales for a percentage change in
  price)

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4.2.2 Demand Function and Econometric Equation

• Econometric Equation of Sales
• where the income elasticity of sales (percentage
  change in sales for a percentage change in
  income)

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4.2.2 Demand Function and Econometric Equation

• Elasticities
• Useful for strategic pricing
• Price inelastic means that revenues will rise
  with a price increase
• Income elastic means that sales and revenues are
  very sensitive to the level of economic activity

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4.2.2 Demand Function and Econometric Equation

• Econometric Equation of Sales
• Useful only if secondary information is available
  or can be estimated
• Secondary information would be the estimation of
  a demand equation based on similar product sales
  and data
• Estimate for another similar product where the
  data is available and use to project sales and
  strategic decisions
• Typically used for projections by mass market
  businesses with a history of sales and price
  information

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4.2.3 New Product Life Cycle Curve Bass Model
or the S Curve

• The marketing research literature has concluded
  that new product life cycle curves typically
  follow an S pattern

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4.2.3 New Product Life Cycle Curve Bass Model
or the S Curve

• The new product sales model explains this S-curve
  shape based on diffusion theory.
• Diffusion theory is actually a theory of
  communication regarding how information is
  dispersed within a social system over time.
• The consumer product adoption process based on
  relative adoption time categorizes individuals as
  
• innovators, early adopters, early majority, late
  majority, and laggards.
• Diffusion theory can be used to develop a
  systematic method for projecting sales that is
  more justifiable then rationalized conjecture
• Room air conditioners, TVs, VCRs, PCs, cell
  phones to name a few products, all followed a S
  curve form of market saturation

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4.2.3 New Product Life Cycle Curve Bass Model
or the S Curve

• There are at least three major types of models
  that have been proposed for forecasting new
  product first purchase sales
• Pure Innovative Models (e.g., Fourt and Woodlock
  1960)
• Pure Imitative Models (e.g., Fisher and Pry 1971,
  Mansfield 1961)
• Combination Models (e.g., Bass 1969)

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4.2.3 New Product Life Cycle Curve Bass Model
or the S Curve

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4.2.3 New Product Life Cycle Curve Bass Model
or the S Curve

• where
• Qt number of adopters or unit sales at time t
• p coefficient of innovation, or the likelihood
  that somebody who is not yet using the product
  will start using it because of mass media
  coverage or other external factors Van den
  Bulte (2002)
• q coefficient of imitation, or the likelihood
  that somebody who is not yet using the product
  will start using it because of "word-of-mouth" or
  other influence from those already using the
  product Van den Bulte (2002)
• M market size, or ultimate number of adopters
  or unit sales
• A cumulative number of adopters or unit sales
  to date

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4.2.3 New Product Life Cycle Curve Bass Model
or the S Curve

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4.2.3 New Product Life Cycle Curve Bass Model
or the S Curve

• Use the Bass Model
• Obtain p and q from a similar type of product
  from the marketing literature or estimate them
  for a similar product
• Estimate own M (or size of market for your
  product) and first year sales or adopters
• Use M, p, and q to predict Q and A, then apply to
  predicted price to obtain projected revenues

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4.2.4 Growth Rate Escalation Method

• Naïve prediction model
• Assumes growth rate(s) and used to escalate
  sales
• Based simply on compound growth rates
• Usually not based on any theory or experience or
  assumption other conjecture
• Difficult to justify

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4.2.5 Market Potential and Saturation Method

• Based on analysis of overall size of market and
  levels of penetration by your venture
• Similar to S curve as its based on market
  potential
• Different than S curve as the S curve is based on
  assumed overall size of market for the venture
  only
• S curve assumed market size (M) should be
  benchmarked to overall size of the market for
  long-term market share

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4.2.6 Estimating Expected Revenues from Large,
Discrete Contracts

• Based on knowledge of and relationships with
  targeted potential clients
• Revenue projection based on expected value of
  revenues generated from each project individually
• Develop customer sales cycle and typical time
  line then use to project each projects revenues

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4.2.6 Estimating Expected Revenues from Large,
Discrete Contracts
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4.2.6 Estimating Expected Revenues from Large,
Discrete Contracts
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4.3 Projecting Expenses

• Total Cost (TC) Fixed Cost (FC) Variable Cost
  (VC)
• In economic theory, FC includes rate of return
  equal to the opportunity cost of capital to the
  equity investors
• Variable cost items are driven by sales by
  definition
• Cost of goods sold purely driven by sales
• Fixed costs items are driven by scale of the
  business and business type
• Cash Flow Cycle identified employees, materials,
  and fixed assets
• Capital intensive businesses require high levels
  of fixed assets compared to other factor inputs
• E.g., consulting firm have little fixed cost
  physical product manufacturing businesses such as
  electric power generation or petroleum extraction
  have very high fixed cost

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4.3 Projecting Expenses
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4.3 Projecting Expenses

• Review microeconomic theory of cost helpful in
  understanding how costs grow and defining a cost
• Review TC, average TC (ATC), average FC (AFC),
  and average VC (AVC) and marginal cost (MC)
  curves
• Review long-run average cost curve and economies
  of scale

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4.3 Projecting Expenses

• See integrated pro forma financials template for
  typical expense items for a NV
• List all assumptions to your pro forma revenue
  and expense projections as notes to accompany pro
  formas
• Pricing (value-based, cost-plus)
• Method for forecasting sales
• Timing of fixed asset commitments
• Terms of loans
• Salaries by person or title
• Describe assumptions of any material expense

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4.3 Projecting Expenses
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4.4 Links Between Cash Flows, Net Income, and
Balance Sheets

• The three financial statement are interdependent
  and linked by accounting methods
• Income Statement changes affect Balance Sheet and
  Cash Flow (e.g., higher profit may lead to
  increased cash balances).
• Balance Sheet changes affect Income Statement and
  Cash Flow (e.g., borrowing leads to interest
  expense and reduces taxes).
• An financial model should integrate the
  statements
• Ideally, pro forma income, cash flow, and balance
  sheet financial statements and sources and uses
  of funds should be developed
• The most important is the statement of cash flows
  as the NV financial decisions, planning and basis
  for survival are based on cash flow and cash
  needs

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4.4 Links Between Cash Flows, Net Income, and
Balance Sheets

• Profitability is not the same as cash flow
• Non-cash revenues may increase NI but reduce CF
  as credit is extended to the customer
• Capital acquisitions will decrease CF by the
  amount of the purchase at the time of payment but
  not affect NI
• Only affect NI when depreciated or expensed
  over its useful life depreciation will affect NI
  but not CF
• Reflected as a fixed or long-term asset and
  liability is recorded based on how funds obtained
  (e.g. credit long-term debt)
• See integrated pro forma income, CF, and balance
  sheet templates

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4.4 Links Between Cash Flows, Net Income, and
Balance Sheets

• Pro Forma Forecasting No track record to rely on
• Yardstick Approach
• Comparable firms in relevant dimensions
• IPO prospectuses
• Other data sources
• Value Line or other investment information
  sources
• Trade Show Exhibits and Conference Paper
  Presentations
• Public Record Bids

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4.5 Assessing Financial Needs

• Based on the shortfall in cash flow projection
  from pro formas
• Identifies specific sources of cash
• CF from operations
• CF from loans (identify creditors and amounts)
• CF from equity (identify investors and amounts
  may be a confidentiality or strategy issue here)
• Identifies uses of cash and schedule of needs

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New Company Assumptions

1. Development will require 18 months, during which
   no sales will be made.
2. Initial sales of 10,000 in the 19th month.
3. Sales will grow 8 per month in real terms for
   three years and at the inflation rate thereafter.
4. Cash operating expenses during the development
   period of 15,000 per month, plus inflation.
5. Inflation at 9 percent per year.

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New Company Assumptions

• A 200,000 production facility will come on line
  at the end of month 18. The facility is to be
  leased by the company for the first 5 years of
  operation, with monthly payments of 3,000.
• Gross profit of 60 of sales revenue on materials
  costs with trade discounts.
• Selling expenses of 15 of sales.
• Administrative expenses of 2,000 per month
  beginning in month 19, growing at the inflation
  rate, plus 15 percent of sales (Included in
  development period operating expense total).

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New Company Assumptions

• Entrepreneurs salary of 3,000 per month through
  the first full year of sales. (included in
  initial operating expenses), increasing
  thereafter by 500 per month.
• Corporate tax rate of 45. No loss carry forward.
• All sales are for credit. The average collection
  period is 45 days. No discount for prompt
  payment.
• The inventory turnover rate is 5 times per year,
  measured against ending inventory.

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New Company Assumptions

• The company desires to maintain the greater of 30
  days sales in cash or 10,000.
• All materials are purchased on credit, with terms
  of net 30. The company anticipates paying in
  time to receive the discount. The payables
  period is 10 days.
• The entrepreneur will borrow any funds necessary
  at a rate of 1 per month.
• Initial investment by the entrepreneur of
  200,000. Additional financing as needed by
  borrowing on a line of credit.

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4.5 Risk Analysis

• Modeling uncertainty is more important for a NV
  than established business
• Expected projection is an anchor for forecasts of
  uncertainty / scenarios
• Base on comparable companies
• Envision alternative realistic scenarios and
  reflect in pro forma projections and estimate
  probabilities
• Determine 3-4 key risk driving variables and
  re-do projections based on these scenarios
• Use monte carlo simulation for large NV
  investments

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4.5 Review Various NV Pro Formas

• Discuss results from cases