Archive | May, 2012

Day 5- Business Plan

29 May

“No plan survives contact with the enemy” Moltke, Chief of Staff for the Prussian Army.

Imagine you’re a marine and your mission is to move supplies from point A to point B. You have your route mapped out and begin your mission only to find a series of land mines in your way and cannon fire hailing down on you. This is the point where you need to “pivot” and throw the original plan out the window. If you’re stuck in the planning mentality, and oblivious to whats going on in real time, you’re as good as dead!. The same goes for business.

Business plans are great, as are five year forecasts, and all the other hogwash business speak the denizens of MBA land have unleashed on us. In all seriousness, you really need to have an innovative business model. You don’t need to recreate the wheel to be a successful small business owner, you just need to create a superior experience for your customer. What about your model is sustainable and innovative? That is what I think separates phenomenal businesses from the mediocre.

For the formalities involved in writing a business plan please see Brad Feld’s exhaustive analysis here;

Day 4- Startup Stock Options

15 May

One of the most important tools a start-up has in it’s arsenal is it’s pool. And I am not talking about the one filled with H20, although that’s a real possibility, if you utilize the option pool correctly. Options are typically set aside to incentivize key hires and star personalities you want involved in your business.  They offer an upside in the business and don’t require the founders limited supply of funds. Just like an option on the public market, private market options are a contract between two parties, specifying a price the options can be purchased for at an agreed upon later date. A vesting schedule serves to restrict when the holder of an option can cash out. So if you are granted 100k options, a typical schedule may dictate 1/4 of your options can be exercised after year 1, another quarter in year 2 and so on. This ensures alignment and continuity in a business…if you jump ship and leave for another company, your vested options will expire worthless.

An options value is tied to the total number of options issued. So you should ask the total size of the option pool when your are offered them, and then simply divide your share to calculate % ownership. Keep in mind, as a founder, options are dillutive to your founders shares, but only when/if they are exercised.


Day 3- Cash Flow

11 May

It’s all about the Benjamin’s! This is going to be a real quick post. Heading to Boston on a jet plane very shortly. Cash flow statements are useful, or so I am finding out, to adjust for the quirky accrual accounting system. You may be showing a profit on your income statement, but that speaks nothing to today’s liquidity and to your ability to meet current debts. The cash flow statement is a measurement of cash coming into and out of your business for a given interval of time. It excludes non cash items like depreciation, write offs, or bad debt to name a few and is often used as a barometer for a firms ability to meet near term obligations.

The three main categories on a cash flow statement are operational, financing, and investing.

  1. Operational are things associated with the production and sale of a company’s product and collecting customer payments
  2. Financing deals with the inflow of money from investors such as banks and shareholders as well as outflows to shareholders in the form of dividends as the company generates profits
  3. Investments are the purchase and sale of assets, loans made to suppliers or received from customers, payments related to merger and acquisitions.

Day 2 – Income Statement

9 May

Well I survived the first day of my faux Harvard MBA. Day 2 is going to involve my insights on the Income Statement. I am departing from yesterdays format and will just provide some interesting insights that I think might be helpful to future budding venture capitalists. For a more detailed analysis you will need to follow the links I provide…I will be back later tonite…and there will be hell to pay if I can’t find good content  🙂

(ultimate demarcation line)________________

Okay I am back, disclaimer…no brilliant insights from a couple hours of studying the income statement.  I did find a nice post on the income statement from Fred Wilson. His big thing is profit margins and operating income ( no surprise here).

(Revenue – Cost of Sales) / Revenue = gross profit margins

He looks for companies with high gross profit margins because they have ample cash left over after making a sale and can pay for other expenses of the business. Buffet is big on this number as well. Particularly trending numbers over a period of years, which may indicate a sustained durable competitive advantage. This advantage may derive from operating in an industry with a high cost of entry (think drilling for oil), or certain patents preventing other entrants. Breaking out the cost of revenue is critical too, because it can change (positively or negatively) with increasing revenue.

Fred also emphasizes the importance of operating income, or income after expenses. If positive you are in the black and making money, if negative you are losing money. For a start-up you may start-out in the red as you attempt to scale your way to profitability. Great gross profit margins and good breakthrough top line sales (at least initially) may not be enough to cover operating expenses. But if the company is structured properly and operating expenses / fixed costs are controlled over time, you could be well on your way to profitability.  Fred likes to see income statements for start-ups broken down month by month for the course of say a year. This will give him a sense of how revenues, costs and profits are trending.

Remember numbers can be deceptive and don’t tell the whole truth. Simply looking at the income statement speaks nothing about employee moral, how great the product is, how engaged management is, or a host of other intangible factors, which are critical to the success or failure of a business.

Thanks Fred and Buffet.

Day 1- Balance Sheet

8 May

Deconstructing the balance sheet will be the first post in our 15 day journey to a Harvard MBA.

The balance sheet’s purpose is to provide a detailed listing of the company’s assets and liabilities. It is not unlike a personal credit report. If you think about your own financial net worth, you probably have a number of assets such as a home, a vehicle, a stock portfolio, cash in a savings account, and so forth. You also likely have a list of liabilities or debts, such as a mortgage, a car loan, electric or telephone bills that have not yet been paid, etc. This concept is directly analogous to a company, and the balance sheet lists out all of these.

Like the income statement, an investor needs to be aware of the potential accounting assumptions made for the balance sheet. Obviously, some line items are unambiguous. For example, the worth of cash in the bank is a pretty straightforward value. However, the worth of a 5 year old computer, or an undeveloped piece of land, are less concrete. For most of these kinds of items, a company will book their value at whatever was paid for it. While items that depreciate, like computers, are usually de-valued over a period of time, that piece of land will likely appreciate over time, and the current value may not be reflected on the balance sheet. This can make the company more valuable than it appears (some value investors refer to these as “asset plays”).

For financial companies, a ton of assumptions are made on the balance sheet. The actual value of a loan is very difficult to calculate due to variable interest rates, risk of default, risk of early payment, etc. Take that reality and multiply it by the millions of loans a large bank has outstanding, and you begin to see why investing in banks is such a difficult and risky endeavor. However, since the Magic Formula throws out financial stocks, we won’t discuss that in much detail here.

One other thing to be generally aware of is that both assets and liabilities are categorized as either “current” or “long-term”. The line items falling into the “current” category are assets that the company expects to be converted into cash within the next 12 months, or liabilities that are expected to be paid off over the next 12 months. “Long-term” assets and liabilities have a longer time horizon for being liquidated or covered, respectively.

To understand the balance sheet, will continue with our previous example, Intel (INTC). Here is it’s year end 2007 balance sheet. Again, gray columns are calculated values, and light blue columns are calculated metrics. All values are in millions of dollars, and items in parenthesis represent liabilities. The balance sheet often has line items that are specific to a line of business or a company, so some of these you won’t generally see, while others are pretty common.

Cash & Equivalents: 7,307
Short-term Investments: 5,490
Total Cash Equivalents: 12,797
Accounts Receivable: 2,576
Inventories: 3,370
Trading Assets: 2,566
Deferred Tax Assets: 1,186
Other Current Assets: 1,390
Total Current Assets: 23,885
Property, Plant, Equipment, Net: 16,918
Goodwill: 3,916
Marketable Equity Securities: 987
Other Long-term Investments: 4,398
Other Assets: 5,547
Total Assets: 55,651
Accounts Payable: (2,361)
Accrued Compensation and Benefits: (2,417)
Accrued Advertising: (749)
Deferred Income on Shipments: (625)
Other Accrued Liabilities: (1,938)
Income Taxes Payable: (339)
Short-term Debt: (142)
Total Current Liabilities: (8,571)
Long-term Debt: (1,980)
Long-term Income Taxes Payable: (785)
Deferred Tax Liabilities: (411)
Other Long-term Liabilities: (1,142)
Total Liabilities: (12,889)
Total Equity: 42,762
Debt-to-Equity Ratio: 4.96%
Current Ratio: 279%

A brief explanation of each line item:

Cash & Equivalents. Just what it sounds like. This is very liquid cash in a bank account, or an investment that can be sold quickly at a known price.

Short-term Investments. Often classified with cash. Examples of these would be a CD or bond with a maturity under 12 months.

Total Cash Equivalents. Simply the above two added together. For analysis purposes, these assets can be liquidated at the stated value at any time.

Accounts Receivable. Amount owed to the company for products, but not yet received. An example of this would be when a computer maker like Dell (DELL) buys Intel parts on credit but has not yet paid off the balance. Intel is owed this balance, and it is booked here.

Inventories. Value of processors, chipsets, and memory that have been manufactured but not yet sold to customers. This is an important number to watch for a company like Intel, because the value of this inventory declines rapidly as newer chips are rolled out.

Trading Assets. This is a line item you don’t generally see. In this case, they represent short-term debt instruments (bonds) that Intel has invested some of it’s cash in to earn a higher return.

Deferred Tax Assets. An accounting by-product. Remember in the income statement articlethat we mentioned that tax provisions were an assumption of how much the company would owe in taxes? Often those assumptions turn out to be a bit off, and the company either owes more or less taxes than it set aside. Since these are assets, at some point in the past Intel overestimated it’s tax liability, and is carrying the difference on the balance sheet. This account can be used to make up the difference on the downside in the future (which Intel expects to do, as it’s listed as a current asset to be used in the next 12 months).

Other Current Assets. A catch-all line item. For most companies, you need to go into the footnotes to get the details here. This is especially important if it’s a large value, as all kinds of dirty secrets can be hidden in the “other” line items. For Intel, the bulk of this number (over $1 billion) was due to a pre-payment on a stock buyback authorization, which was neatly offset by a $1 billion accrued liability.

Total Current Assets. All of the above added together. These are the assets Intel expects to convert to cash within the next 12 months.

Property, Plant, Equipment – Net. The value of all of Intel’s factories, administrative buildings, computers, chipmaking equipment, and so on. Sometimes the balance sheet will show an “at-cost” figure and then “accumulated depreciation”. Whenever a company buys equipment, it will set up a depreciation schedule and degrade the value in set intervals. The net figure is “at-cost” minus “accumulated depreciation”.

Goodwill. When a company (acquirer) purchases another company (acquiree), the amount paid over the Total Equity of the acquiree is carried as goodwill on the balance sheet of the acquirer. The idea is that this premium represents the intangible assets and future earnings power of the acquiree. This is an accounting phantom – this number has no tangible value and is often written down (impaired) if the acquired assets prove not to be as valuable as expected. Since it is essentially a made-up asset, strategies like the Magic Formula disregard it totally and assign it no worth.

Marketable Equity Securities. Some cash rich companies like Intel will invest a portion in equities, much like you or I would invest our excess cash in a stock portfolio. Intel holds stock in companies like VMWare (VMW) and Micron (MU), both of whom are part of joint ventures with Intel. It is fairly rare to see public companies hold a significant amount of equity assets on the open market.

Other Long-term Investments. These represent minority stakes in other companies that were not purchased on the open market. In 2007, this value mainly represented Intel’s minority stake in NOR flash maker Numonyx and WiMAX maker Clearwire.

Other Assets. Another “other” category that you need to dig into the footnotes to understand. For Intel, these include other non-marketable equity investments, derivatives for managing foreign exchange risk, estimated value of intangible assets, and direct investments in joint ventures (IM Flash Technologies with Micron, for example).

Total Assets. The cumulative value of all current and long-term assets.

Accounts Payable. Money that Intel owes to suppliers but has not yet paid in cash.

Accrued Compensation and Benefits. This is money Intel owes it’s employees for hours worked, earned but unpaid bonuses, and benefits such as unused paid time off.

Accrued Advertising. Most companies lump their advertising contract obligations in with accounts payable, but Intel has a separate line item specifically for it. This is money the company owes advertising outlets but has not paid off in cash.

Deferred Income on Shipments. This is money that has been paid to Intel by customers, but that Intel has not yet shipped. It is carried as a liability to represent the obligation Intel has to actually ship the product that has been paid for! This concept can be applied for any company’s “deferred income” liabilities.

Other Accrued Liabilities. Another catch-all “other” line item. Most of it is the aforementioned prepaid share buyback. Hedging portions of the derivative contracts and equity holdings are included here, but there are not many hard details on these in the 10-K (annual SEC filing).

Income Taxes Payable. Estimated tax liabilities that Intel will have to pay within the next year.

Short-term Debt. Usually a bank credit line that needs to be paid off in a short amount of time (not unlike a credit card). Many companies also have a “Current Portion of Long-term Debt” line item which reflects how much of their long-term bonds are maturing within the next 12 months.

Total Current Liabilities. A sum of all the above liabilities. These are all due to be paid off in within the next year.

Long-term Debt. The total face amount of outstanding long-term bonds issued by the company, plus the expected interest due to be paid on them.

Long-term Income Taxes Payable. This differs from deferred tax items in that Intel has already been charged with this amount of tax.

Deferred Tax Liabilities. See above “Deferred Tax Assets”. The same idea, except for this line item, Intel underestimated the tax they would have to pay.

Other Long-term Liabilities. Yet another “other” category! Intel lumps a lot of things in here, mainly uncertain tax liabilities and interest payment obligations.

Total Liabilities. All current and long-term liabilities summed up.

Total Equity. Calculated as (Total Assets – Total Liabilities). This is Intel’s “net worth” – the amount of assets left over for common shareholders like us after all liabilities are paid off. Theoretically, this is the liquidation value of the company.

Debt-to-Equity Ratio. Calculated as ((Short-term Debt + Long-term Debt) / Total Equity). This is a financial health statistic. We don’t want to see a high percentage of debt to equity, because this debt has to be serviced by profits and that takes out our cut as shareholders. In some cases, the debt interest requirements can be higher than profits, or even worse, debt coming due in the next 12 months may not be able to be paid off with cash flow and cash reserves, leading to potential bankruptcy. As a rule of thumb, MagicDiligence looks for a number here less than 70%, although it varies by business. Intel’s is under 5%, so debt burden is not a concern here.

Current Ratio. Calculated as (Current Assets / Current Liabilities). This is another financial health measure that tests the “liquidity” of a company, or it’s ability to cover it’s short term liabilities. The higher the better here. Any number under 100% should be scrutinized, as this could mean that the company will not be able to pay it’s liabilities in the near term. 125% is a decent number to look for, but riskier companies should be required to have a higher figure (175% or better). Intel’s 279% figure is outstanding.”

Thanks to Magic Diligence for providing all of the above content.

3 Keys To Venture Capital

8 May

Thanks to Brad Feld for this-

“VCs only need three rights: Up, Down, and Know What The Fuck Is Going On”

Up: Pro-rata rights. When things are going well (up) a VC wants the ability to continue to invest money to maintain their ownership.

Down: Liquidation preference. When things don’t go well (down), a VC wants to get their money out first.

Know What The Fuck Is Going On: Board seat. Beyond demonstrating that older VCs also swear in public, many people believe that with a board seat comes great power and responsibility. In reality it mainly gives one the ability to know what’s actually going on, to the extent that anyone knows what’s actually going on in a fast moving startup.

I will now add pro-rata rights, liquidation preferences and board seats to the 15 day MBA Program.

15 Day MBA Program

8 May

For the next 15 days I am embarking on a mini MBA experiment. I will attempt to cover a new business topic each day, for 15 straight days, and graduate with a fully accredited Harvard MBA.  Well okay, that may be a bit of an exaggeration, but you get the idea right?

Topics (subject to change)


Day 1) Balance Sheet

Day 2) Income Statement

Day 3) Cash Flow

Day 4) Options / Warrants

Day 5) Business Plan

Day 6) Valuation

Day 7) License / Royalties

Day 8) Patents

Day 9) Lean Start-Up Methodology

Day 10) Financing

The next 5 days are open for suggestions….Stay tuned for the first post on the Balance Sheet later today.