Entrepreneur training 4: Financials - Statements, Models & Unit Economics

This week we talked about all the finance a startup founder needs to know. 

We first talked about how to interview your customers, i.e. what kind of questions you should ask. I think this is really useful since if you ask the wrong questions, you can not get what you want. Also, if you don't design your question good, then you will just get a 'Yes or No' answer, which is also not that useful. Instead, you want to get into the customers' head and try not bias them. Ask them what problems do they have, did they look for or used some methods to solve the problem, how that works. You try to understand how they decide, how they do, how they try different things. 

Case study

We discussed the Elite Personal Training case. In this case, two people are planning to start a one-to-one gym training business in London. They face the questions as: Who is the target market? What's the right price to start? It is a very nice case study to show you how to do a survey for the target market, and how to calculate the income, costs etc to get a break even price. Some key concepts are: fixed costs, variable costs, break-even point. Indeed, as an entrepreneur, these are essential to know and estimate before you decide to do the business. 

It is also interesting to see that even though the market size is not that large for them, but because the break-even point for them is really low, therefore, it is relatively easy for them to start the business and get a profit. 

Lecture

After the case study, we talked about the concept of Unit Economics. In a simple word, it is the cost and revenues associated with every transaction you make. 

We then talked about the following 3 concepts:
1. Income statement (also known as P&L - Profit and Loss statement) - this is the continuous movie 2. Balance sheet - this is more like a photograph, two tables showing all the money you have, and all the liabilities. 3. Cash-flow statement. 

Here is a difference between P&L and Balance sheet. 

Your 'real' business plan is (this is what investors will be looking for): 

• cash needs
• hiring plans
• profit projections
• fume-out date
• sensitivity analysis

Why we do financial modeling? To answer the most important & fundamental question: Does this make sense?

The financial model is clarity about your business, it is built from common sense:

• sources of revenue
• sources of expenses
• net income

Basic concepts:

• Price
• Cost
• Revenue
• COGS (Cost of Goods Sold)
• Gross profit = Revenue - COGS
• Operating expenses
• Net profit
• Fixed costs vs. startup costs vs. variable costs
• Gross margin = gross profit / revenue or GM = (Price - Cost)/Price

What do you need for VCs 

1. List of key assumptions
2. 5-year P&L statement

P&L statement, how much negative you need raise, and this is the money you need to raise. First year + Second year + cushion. As the CEO, you should be the first one to do. For the investor, they will challenge your assumption. You need to build this by yourself, since if you hire someone to do it, then you will be in trouble in the first 5 min in front of VCs.

Basic Structure of P&L

• Sources of revenue
  • Hardware, software, or services
  • Realistic & conservative in year 1 & 2
  • Hopeful in year 4 & 5
• Gross profit
  • Revenue minus direct cost of sales (COGS)
• Sources of expenses
  • G&A (general and administration)
  • Sales and Marketing
  • R&D
  • Capex or any other big expense peculiar to your business
• Net profit 

Cheat Sheet to make P&L

• Make sure that Year 5 revenue is between $50m to $100m (unless you are after Angels only) - State assumptions
• Net Income typically does not exceed 30% - Don't under estimate Y5 expenses
• Ask for enough money to get to the next stage of de-risk (tell us what it is) 

The numbers should all within the zone of reason. For example: When investors look at your P&L, they focus on the percentages. In a software, Research is 8 - 16%, 35-55%, 8-12%. 50 - 100 million in the 5th year.

Take aways

1. Know your key assumptions & have plans to always validate them
2. Financial model provides real insights to your business - do 'what-if' analysis
3. It is not complicated!

Acknowledgements:

All the materials are from the entrepreneurship class at UC Berkeley taught by Naeem Zafar.