Subject line: [Flawless Financials] Presenting Investment Returns Flawless Financials the Financial Forecasting Online Newsletter from Minotaur Financial and David Brode April, 2003 Please pass on Flawless Financials to those in your network. To leave Flawless Financials, follow instructions at bottom. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * This month: Presenting Investment Returns * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * If you're an investor, you want huge returns from your investments. If you're an entrepreneur, to get investment dollars you must communicate how your business will provide huge returns. To make matters more complicated different investors have different criteria: some have IRR hurdle rates, others have a targeted Cash on Cash Return Multiple. Your communications tool is a cap table forecast. A cap table forecast is quite different from what usually passes for financial forecasting. Everyone creates an Income Statement, and most create some form of Balance Sheet or Cash Flow Statement. But even if you believe everything the company says about its forecasted financials, you still would not invest if the cap table wasn't favorable. At its simplest, a cap table simply lists the company's shareholders and their holdings. It gets more interesting quickly when you explore how the cap table is expected to change over time. First, you have to maintain consistency between the cap table and the financial forecasts so that whenever the financials show an inflow of equity there is a corresponding funding event in the cap table. Second, moving beyond the status quo opens up the valuation issue. In order to accurately reflect how many shares are issued to new shareholders who are funding the subsequent rounds of the company, you need to value the company at each point in time. With a valuation at each event, you can calculate what percentage of the company each shareholder holds at the time of exit. And with an exit valuation, we can calculate returns for each investor, be it IRR or Cash Return Multiple. So what kinds of returns should you see on the cap table? The answer varies for each investor. One classic rule of thumb has venture capitalists seeking 40% IRRs. Another has VCs looking for 10-15x returns on cash invested. What are your own criteria or what are you hearing from others with respect to these metrics? Or are you using different metrics, like NPV or the opportunity for $1B in revenue in five years? With this background in place you can address the question we started with: how do you communicate that this is an awesome investment? There are essentially two variables: valuation and funds raised. These change for each round. With a high enough exit valuation, all investors make good money. But there are limits to the exit valuation forecast. Once you have a mature company, investors can apply basic P/E multiples, EBITDA multiples, and revenue multiples to make sure that the exit valuation is realistic. All too quickly the exit valuation stops seeming variable and is bounded in a relatively tight range. The other way investors achieve high returns is with a low entry valuation. This is just another variant on "buy low, sell high." And so now we can see why so many VCs are excellent at driving hard bargains with their investments. A lower entry valuation means the investor owns a higher percentage of the company and receives more of the exit proceeds. The final way to tweak the cap table returns is by changing the amount of investment required. Reducing capital requirements allows current owners to retain a larger percentage of the company, of course, and reducing requirements in future rounds limits dilution for previous investors, thus pumping their returns. Viewed from another angle, the current shareholders can retain a higher percentage of the company if the company can thrive on lower funding. This is part of the efficiency of the capital markets. Capital is expensive, so you have to focus on only buying the amount you need. A good cap table forecasting model is not too complex to build and is incredibly valuable as you play with funding strategies for a company. Whether you share all the information or keep it in your back pocket, it's a powerful tool for all investors and entrepreneurs. Until next month, all the best, David Brode – Minotaur Financial Helping Companies Create Better Financial Forecasts * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Special thanks to Ed Roberto of Newmerix (http://www.newmerix.com). In 1999, Ed providing me with a model that guided the development of Minotaur's cap table forecasting model. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * http://www.brode.net mailto:David@Brode.net 1919 14th Street, Suite 510 Boulder, CO 80302 (303) 444-3300 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Cap Table Model Interested in getting a copy of Minotaur's cap table model? Go to http://www.brode.net/resources/ * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * NEWSLETTER ARCHIVE NOW AVAILABLE Make sure to visit the Minotaur Financial website for the Newsletter Archive at http://www.brode.net/resources/etc. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * (c) 2002 Minotaur Financial, All rights reserved. You are free to use material from the Flawless Financials newsletter in whole or in part, as long as you include complete attribution, including a live web site link. Please also notify me where the material will appear. The attribution should read: "By David Brode of Minotaur Financial. More articles on financial forecasting can be found at http://www.brode.net" * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * To find out more or see if I can help with your financial forecasts, call me to discuss your issues at no charge: (303) 444-3300. I'm very accessible and glad to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * DO YOU LIKE THIS NEWSLETTER? You are welcome to share this email with colleagues who would benefit from better numbers. Your feedback is always welcome and appreciated. Write in to mailto:feedback@brode.net. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * PRIVACY POLICY: I never rent, trade, or sell my email list to anyone for any reason whatsoever. You'll never get an unsolicited email from a stranger as a result of joining this list. To SUBSCRIBE FREE to this newsletter, send an email to mailto:subscribe@brode.net. 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