Funding By Numbers (Part 2 of 2)

Posted: August 23, 2009 in Uncategorized

Last week I put up a guest post by David Kirk on funding your start-up. The post generated a lot of very interesting discussion so i am happy to put up part 2:

Knowing VC arithmetic and fund metrics is only half of the equation.  The numbers in your business plan’s financial forecasts need to positively answer the question “Can I make money with this deal?”

I have three questions, which help me answer that.

  1. “Is this a big market?”
  2. “Is this a hot product?”
  3. “Is this the team that can deliver?”

But what is a “big” market and a “hot” product?  It used to be we looked for a $100M of revenue in year-5 in a $1B market.  Interesting how that $100M looks strangely similar to the year-5 revenue for exit valuation?  It all comes down to “returns”.

Remember to scale down according to your investment needs and the returns needed by the VC.  But even if you scale down, the ratio here is interesting.  Basically it projects a 10% market share of the available market [I’ll return to available market later.]  That’s a good market share target.  Greater than 20% market share and you’ll see eyebrows raised and eyes rolling back.  Less that 5% and you don’t have the ambition to get a “yes” to question three above.

OK. Available market.  This is important, but skip this section of you already understand this.

There are three elements of market size; total market (TM), total available market (TAM) and total serviceable market (TSM).  For starters and simplicity I’m going to ignore Total market – I can almost hear that sharp intakes of breath by countless business school professors!  The other two are meaningful:

Total Available Market = size of the market that would buy your product

Total Serviceable Market =  size of market that you will be selling to.

By way of example, lets say you have a product that disables a laptop if it is stolen.

The Total Market (which is meaningless) is the total number of PC’s  in the world.

But this product only runs of Win XP, so the Total Addressable Market is the total number of PC’s, worldwide, running WinXP.  This is the count of your potential pipeline of customers.  The target customer.  Note, you may also segment this further by identifying further target customer attributes, e.g. English speaking.

And, if you only ever plan to sell in Europe, then your Total Serviceable Marketable is the total number of PC’s, in Europe, running WinXP.  Now you have a basis for projecting market share and strategic growth.

Without expanding your territory or adding additional OS support to your product, your market share is projected sales/Total Serviceable Market.  You can increase your market, both available and serviceable, by expanding your product and your territories.  That’s your business decision.  As a potential investor, I just want to know I can make money whichever.

Welcome back to those you knew all that.

Now for your financial projections.  The old rule of “no hockey sticks” is still relevant.  And year-over-year growth is follows the laws of operational physics.  I’ve never seen a $10B company double [outside of acquisition], but I have seen a company quintuple its revenues in the early years.  Whilst there is no pro forma for revenue growth, I like to apply an operational realistic growth curve to the first five years of financial projections.  If year-1 is N, then

Year-2 over Year-1 can be 500%, giving a projection of 5N

Year-3 over Year-2 can be 300%, giving a projection of 15N

Year-4 over Year-3 can be 200%, giving a projection of 30N

Year-5 over Year-4 can be 180%, giving a projection of 54N

Year-1 MUST be a bottoms up calculation, showing that you know the operational reality of the sales channel for your product, and the channel MUST be scalable.  Then just make sure that 54N is between 5% and 15% of your addressable/serviceable market!

Just a truism on business plan financial projections.

Revenue NEVER comes as fast as you think.

Cost are ALWAYS greater than you planned.

I expect that, its not a negative the first time, possibly even the second time … stuff happens, but lets hope the error is on the side of planning, verses execution.

And that brings me back to the final question … “Is this the team that can deliver”.  At the end of the day, we invest in PEOPLE.  There are LOTS of great ideas, big markets and hot products, but the road to financial nirvana is paved with teams of people that just couldn’t deliver.

I rate the management team as:

A … past champions (serial entrepreneurs), they’ve been up the hill before and just need a sounding board

C … first time in the game, need adult supervision
think Bosack & Lerner and Morgridge [Cisco]

Case and Kimsey [AOL]

Andreessen and Clark [Netscape]

Page & Brin and Schmidt [Google]

B… played in a few games, but never scored

In all cases, with  the right VC, you get the operational experience you need.

And that is the first 1% of what it takes to get a company funded and make a bucket load of money.

  1. David Kirk says:

    Sorry for bad news here, but I was researching trends in exit valuations for software companies. I use x2 for TTM Revenue, which now turns out to be a tad generous … here’s a snip from

    Trends in M&A Valuations
    On a TTM basis, the software industry’s benchmark exit metric fell in 1Q09 to 1.3x TTM revenue, down 19% from 1.6x TTM revenue in 4Q08, and down 35% from 2.0x TTM revenue in 2Q08 (see chart below).

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