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An important component that affects a company’s ability to raise capital, as well as to finance its development by using internal resources, is the growth of sales. However, it is important to understand that the substance of the growth in sales is more important than the actual pace of such growth.

Paradoxically, many companies which demonstrate a fast sales growth actually need more outside financing. The reason for this is that the company has to prepare for the increased sales by making considerable investments in equipment, manpower, raw materials, and inventory, which are made before the proceeds from the sales are received. Many entrepreneurs fail to plan their cash needs for accelerated growth and run into financial difficulties at times that are supposed to be good from the company’s point of view. Although, as mentioned above, investors prefer companies with rapid sales growth, various factors could delay their investments, such as a forecast of a problematic situation on the capital market, or a projection that the pace of growth of an industry will not last much longer.

This dimension is crucial for attracting investments, as more and more investors prefer to “cut their losses” than to continue investing in rapidly growing ventures, whose future capital need on their path to profitability makes them too risky. For instance, during 2000 and 2001, many Internet ventures closed down. One of the most spectacular closures was perhaps the grocery and gasoline division of Priceline, in which more than $300 million were invested and that was shut down after less than one year of operations, as it was anticipated that hundreds of millions of dollars would have to be invested before it turned profitable, and the probability of raising this capital at a period of “hostile” capital markets was predicted to be slim. Along with companies in the public sector, there were also many spectacular failures in the public market, such as eToys, that consumed hundreds of millions of dollars before declaring bankruptcy. One of the reasons for this failure was that eToys was unable to secure additional sources of capital that would sustain it until it could (possibly) start generating net positive operating cash flows.

taken from; From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital

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There is no doubt that forecasting the business results of a company in its early stages of development is more of an art than an exact science. Nevertheless, financial forecasting at these stages is more important than for developed businesses. Given the scarcity of available sources of capital, the company must assess its business development decisions at every stage, while choosing the alternatives that will yield the best return for its shareholders (including the entrepreneurs). The main difference in comparison to a developed business is the level of uncertainty that may be addressed by examining different scenarios of parameters such as cost structures, market sizes, growth rates, and market profitability.

Companies must always examine scenarios that take into account the possibility of partial success. There is almost no greater hazard for businesses than managers who do not account for the possibility of partial success or failure of a project. Just like the preparation of strategy for war takes into account pessimistic scenarios such as accidents or defeat which would necessitate a retreat, companies too must prepare for scenarios in which not all optimistic assumptions materialize.

taken from; From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital

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When forecasting the revenues and expenses of a company when it enters the market, it is important to rely on the statements of similar publicly traded companies, in order to examine their cost structure and profit margins. Such an examination is crucial, since it enables one to appraise the reasonableness and soundness of the assumptions underlying the venture’s financial model. In addition, it enables one to examine whether the startup will be able to compete with such companies when it goes public. For instance, if the profit margins are low due to fierce competition among many players in the market, the startup will find it hard to break into the market, unless it can present a considerable improvement on the expected products of the existing and anticipated competitors in the market at that time. Sales volumes will probably derive from the size of the projected target market. Data on the target market at the time of product launch are available from many sources—some public and some in the form of reports published by research companies. In addition, in different cases, and in particular when the company is about to create a new market, tailored research that is conducted by or for the company should be used, in order to estimate the size of the potential market.

The data included in the statements of public companies should, however, be treated cautiously, since these are mostly companies that have already passed the test of investors before going public and therefore do not necessarily represent the average company in their field. Financial data and ratios may also be utilized—either from publicly available sources or from quotes for similar projects—with respect to employee compensation, project pricing, and so on.

Forecasting a company’s scale of operations is complex, and in many cases companies will resort to technical and financial experts for such estimates. Even if the estimated market is large, and even if it is forecasted that the competitive situation of the market will not bite into the company’s profitability, the company has to estimate the market share it can achieve and maintain. Determining the market share which the company can achieve is complicated, and setting targets such as “we will obtain 10% of the market” must be based on defendable assumptions. Otherwise, it will not be treated seriously by investors and, which is worse, could lead to erroneous strategic decisions by the company. A later section will discuss further aspects of market analysis.

taken from; From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital

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The cash flow statement is divided into three components describing the changes in the company’s cash flows from operating, investing, and financing activities. We will first demonstrate how the cash flow statement may be constructed on the basis of the company’s other main financial statements, namely the balance sheet and the income statement. We will then review the three components of the cash flow statement: the cash flows from operating activities, investing activities, and financing activities. The analysis proposed here is essentially economic, and although it is consistent with the accounting standards for the reporting of cash flows in countries such as the United States, it is not constructed according to such reporting (GAAP) standards.

The starting point for analyzing a company’s cash flows is the cash item in the company’s balance sheet at the beginning of the period, and the end point is the cash item at the end of the forecasted or analyzed period. The change in the company’s cash positions is the difference in its cash between these two points in time. This difference takes into account all of the movements and transactions in which the company was involved. Therefore, this figure alone is insufficient to understand the company’s cash needs, cash generation, and cash consumption over the period. Clearly, the value of cash infused into the company as a result of the sale of products or services is different from an inflow of cash to the company created by raising new capital.

The company’s cash flow from operating activities is composed, in principle, of actions revolving the sale of products and services. Accordingly, expenses relating to the creation of such cash flows, such as the acquisition of raw materials, sale expenses, marketing expenses, and general expenses, as well as tax payments, are some of the components of the company’s cash outflow resulting from operating activities.

The company’s cash flow from investing activities is composed of actions such as the sale of real and financial assets or the repayment of long-term loans given to third parties. Accordingly, acts such as the acquisition of assets and investments in equipment and long-term financial assets are some of the components of the company’s cash outflow resulting from investing activities, as are the receipt of dividends and interest from real and financial investments. The main component of the cash flow from investing activities is usually the change in the company’s net fixed assets. As mentioned above, the company’s net fixed assets at the end of a period are equal to its net fixed assets at the beginning of the period, plus assets purchased over the period, minus depreciation accumulated over the period and minus net sales of assets sold over the period.

Finally, the company’s cash flow from financing activities is composed of shares and notes and debentures issued and long- or short-term loans taken. Accordingly, the re-purchase of the company’s own shares, repayment of notes and debentures and other long-term debts, and the payment of dividends and interest on debts compose the company’s cash outflow resulting from financing activities.

taken from; From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital

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• Short-term liabilities— This section includes overdrafts, commercial paper issued by the company, and any component of long-term debt payable in the coming year. This item also includes all short-term debts to suppliers of various services and products (accounts payable) and accumulated expenses (expenses accumulated but not yet paid), such as unpaid salaries and taxes not yet paid to the tax authorities.

• Long-Term debt— This section includes sub-items reflecting liabilities due later than one year after the date of the balance sheet. It includes, for instance, bonds issued by the company and deferred tax liabilities resulting from differences of timing between the recording of revenues and expenses for tax purposes and their reflection in the financial statements. Let us assume, for example, that the car bought by Speed for $20,000 may be depreciated for tax purposes over two years (namely, with an annual depreciation of $10,000). As mentioned above, for the purpose of the financial statements, a straight-line depreciation over five years was calculated (i.e., $4,000 per year). Since the difference between the two depreciation methods is $6,000, the company is deferring the payment of tax on revenues in the amount of $6,000. Assuming that the applicable tax rate is 20%, then the tax authorities are, in fact, lending the company $1,200 per year in the first two years, to be paid back from the third year forth. This loan from the tax authorities is itemized on the balance sheet as deferred taxes liability. This item includes differences of timing vis-à-vis the tax authorities under several items, and in many cases increases every year due to ever-increasing assets, assuming that the rates of depreciation for tax purposes are higher than the rates of depreciation in the financial statements. However, since these are timing differences, the company should record a deferred tax item on its balance sheet. Note that similarly, if the company accumulates losses over several periods, but forecasts profits amounting at least to these losses, then the company can record a tax asset in the amount of the tax it will not have to pay over the coming years due to its accumulated losses.

• Equity— The company’s equity represents the value of its assets after deduction of its liabilities, and it belongs to the company’s shareholders. This item includes the company’s paid-up capital (namely, the amounts paid by the shareholders in consideration for their shares), the company’s retained earnings and other items reflecting various reserves due to unrealized changes in the value of various assets and liabilities.

  Another important component of a company’s equity is treasury stocks, namely, shares issued by the company but re-purchased by it. From the economic point of view, a purchase of the company’s own shares constitutes an alternative to paying dividends, since the company is, in fact, spending money that is transferred to the shareholders, who may sell their shares to the company. From the taxation point of view, a re-purchase of shares is usually better for shareholders than the distribution of dividends that is subject to each individual shareholder’s highest tax bracket (in the United States). A re-purchase of shares, on the other hand, affects the price of the shares but does not impose any tax liability on the shareholders, unless they choose to sell their shares (and even then they pay a capital gains tax, which, in the United States, is lower than the tax imposed on dividends).

taken from; From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital

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• Cash, cash-equivalents and securities— These are the first among the company’s current assets. Cash, cash-equivalents, and securities include, except for the cash in the company’s bank account, all short-term deposits owned by the company and traded securities, including treasury bills. The guiding principle underlying the classification of these assets is that they entail a relatively low risk in proportion to their value at the time of liquidation, and can be liquidated quickly (usually, within less than three months).

• Accounts Receivable— Since most companies do not receive payment in cash for all of their sales, almost every company that has reached the stage of sales has an Accounts Receivable (or Receivables) item. These are short-term customer debts that the company records on its balance sheet after offsetting allowance for doubtful debts which it does not expect to collect. For example: a company by the name of Speed is owed $1,000 by its customers, but predicts that only $800 will be paid. The company will present in its balance sheet a net amount of $800 under this item, representing the portion of the debts that the company expects to collect. This amount is produced by deducting an allowance of $200 for doubtful debts from the gross debt of $1,000.

• Inventory— Inventories are assets in various stages of production that the company expects to sell as products. Inventories are divided into several types in accordance with their stage along the production process. Companies usually specify the types of inventories they have, since investors attribute a different value to different types of inventories. For instance, in most cases, an inventory of raw materials is easier to liquidate than an inventory of products in progress. A manufacturing company will generally have three types of inventories: an inventory of raw materials, an inventory of goods in process, and an inventory of finished goods. Inventories are estimated according to their cost, not according to the revenue they are expected to produce, unless such revenue is lower than the cost of production (in which case, the principle of conservativeness directs that they be recorded according to their net realizable value). The reporting of inventories in progress, as well as inventories of finished products, usually includes also allocated labor and overhead costs (such as electricity and some of the depreciation of the equipment used to manufacture them).

  When analyzing inventories, it is important to pay attention to the method of recording of the inventories, since a company selling products uses inventories of raw materials and finished products which might be recorded according to different prices. For instance, let us assume that Speed manufactures instruments that it combines with tractors that it purchases. In one month, the company purchased three identical tractors at different prices (according to the order of acquisition): $100,000, $120,000 and $115,000. At the end of the month, the company sold one set of equipment (a tractor on which the company’s equipment was assembled) for $200,000. Obviously, the reported financial results reported by Speed will be affected by the choice of the tractor that constitutes a material part of the sold equipment. If the company uses an inventory method called FIFO (First In, First Out), then, assuming that Speed had no prior inventories, it will report an inventory of $235,000. $100,000 (the cost of the first tractor) will be reported as part of the cost of the equipment sold (see the next subsection for a further discussion of revenues and expenses). If the company uses the method of LIFO (Last In, First Out), then the company will report an inventory of $220,000. According to yet another method, the inventory (and the components of the cost of the goods sold) is calculated according to the average cost of the components of the sale. In our case, the inventory at the end of the period will be reported at: (100,000 + 120,000 + 115,000)*(2/3) = 223,333.33.

• Advance payments— Although companies usually try to defer payments, in many cases they pay in advance for services they will receive after the date of the balance sheet. For instance, companies often pay rent for several months in advance. The principle in the statements is to report expenses and revenues at the time of the economic occurrence of their underlying events. In other words, since the services will be received after the date of the statements, the expenses will be recorded concurrently with the receipt of the service. Therefore, the balance sheet will reflect an asset incorporating the cost for which the services or product was not yet received.

• Long-term assets— Assets that are expected to contribute to the production of revenues over a period longer than one year are referred to as long-term assets. They are divided into two main groups: tangible assets and intangible assets (intellectual property). Tangible assets include real estate, office equipment, production equipment, long-term financial assets, and stocks in other companies. These assets are usually recorded according to their historical value, i.e., according to the price of purchase, adjusted for depreciation.

  The term “depreciation” attempts to reflect the devaluation of assets over their economic life span or usage. The periodic depreciation of an asset is part of the expenses reflected in the income statement. There are various methods for calculating depreciation that are deployed in accordance with the character of the assets, the industry, and the company holding the asset. The most widely-used method is that of the “straight line”: First, the asset’s economic life span is estimated, and a proportionate part of the cost is recorded every year as an expense. For instance, if a car was bought for $20,000, and its economic life span is five years, then $4,000 are recorded every year as an expense, and the asset is reported on the balance sheet with a value that decreases by such amount every year. Another common method is that of the “accelerated depreciation,” whereby the asset is depreciated more in the first years. This method reflects an accelerated depreciation in the first years of the asset’s life. The value of a new car, for instance, is known to decline faster in its first few years.

  There are other depreciation methods, and in many cases the chosen method takes into account the amount of use made of the asset. For instance, consider the case of a factory where one million cars can be manufactured before it needs to be renovated. Obviously, it would be logical to express the depreciation of the factory over time as a function of the number of cars actually manufactured in it.

  Assets appear on the balance sheet according to their historical value, less depreciation and any other devaluation resulting from a decline in their market value below their cost. In fact, the net fixed assets will be equal, at the end of each period, to the net fixed assets at the end of the previous period, plus new fixed assets acquired, minus the net cost of fixed assets sold and minus periodic depreciation and any other reduction in the recorded value of the fixed assets.

  Where the statements of non-American companies are concerned, it is important to understand that in different countries the value of assets may be expressed differently, and in many cases assets may be revalued according to their market value at the time. Fixed assets may be revalued, for instance, in the United Kingdom and in the Netherlands. The principle in these countries is that assets are reflected according to the cost to the company of replacing them. In other words, if the car on Speed’s balance sheet (which, for purposes of this example, will be reported according to British rules) is one year old, then, instead of reporting a depreciated value of $16,000 ($20,000 – $4,000), the cost of a similar used car on the market will be checked. If such cost is $21,000, then the car will be recorded in the balance sheet with this value. This change in value will concurrently be reflected under the item of the company’s shareholders’ equity. In all countries, if the market value of an asset considerably declined below its depreciated cost, and such devaluation is not expected to be remedied, then the value of the asset has to be reduced in the balance sheet by recording a loss as a result of the devaluation of the asset (since such devaluation is in lieu of future depreciation).

  Intangible assets include items such as the cost of acquired patents, trademarks and trade names, franchises, and the cost of investments in other companies above the value of their tangible assets (goodwill). These assets also appear on the balance sheet and are depreciated in accordance with their expected life span, with certain restrictions (in accordance with the accounting rules applicable in each country) with respect to the manner of recording of various assets and liabilities. For example, if Speed bought a license to use a patent that will expire in ten years in consideration for one million dollars, then it will be depreciated over ten years, unless the patent is expected to become worthless after a shorter period of time, or is expected to continue being valuable after it expires.

  Following an accounting rule change, effective from the year 2002, goodwill does not have to be depreciated if its value, as deemed by the company’s management, has not declined.

taken from; From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital

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The company’s business cycle is reflected in its financial statements; the main ones are the company’s balance sheet, income statement, and cash flow statement. The company’s financial statements provide information about its financial condition: The main purpose of the balance sheet is to describe the assets and liabilities of the company on a given date; the main purpose of the income statement is to describe the transactions and changes in the assets and liabilities of the company over a period of time; and the cash flow statement describes the changes in the company’s cash flow over a period of time.

The company’s financial statements are usually prepared in accordance with generally accepted accounting principles (GAAP). In most cases, the company prepares two sets of statements: One is used for reporting to the company’s shareholders and debt holders, and the other, which is based on the tax rules governing the recording of transactions, is used for reporting to the tax authorities. Obviously, the statements report the same business results, but different rules used for different needs create differences between the reported results. The reason for the differences in most cases is the existence of specific directives for tax reporting, as opposed to other financial reporting principles that attempt to reflect the company’s business condition in general.

In order to understand the company’s financial condition and prepare financial and business plans accordingly, entrepreneurs need to understand the meaning of the different statements and the logic behind the reflection of the company’s business cycle. The following explanation of the statements and their components is consistent with the customary reporting rules, but is based on the economic principles underlying them, rather than on the precise reporting rules.

taken from; From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital

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During its incorporation and thereafter, the company issues securities which award their holders certain rights toward the company and toward the other shareholders, in consideration for which it raises money. A security is an instrument that awards its holder an expectation or right to a future stream of payments, sometimes in addition to other legal rights (such as a voting right). In fact, it is a “standardized” contract that is also characterized by property rights. The basic types of securities are shares, preferred shares, and bonds.

• Ordinary Shares— A share is a personal property right that comprises a bundle of rights. These rights include the right to declared dividends and to assets upon dissolution, as well as the right to vote at the company’s meetings.

  A company’s capital stock is divided into several types. In this context, the following principle terms should be mentioned: authorized (or registered) share capital is the capital that the General Meeting has authorized to be issued; issued share capital is the share capital sold to investors; and outstanding share capital is the share capital held by investors. The outstanding share capital is smaller than the issued share capital when the company buys back from the shareholders some of the shares it has issued. The re-purchased shares are called treasury stocks. Equity capital is an accounting term referring to the balance-sheet value of the company’s assets, less/minus its liabilities.

• Preferred Shares— According to traditional corporate law, a preferred share is a cluster of contractual rights, the most common of which is the priority in the receipt of dividends (both ordinary and upon dissolution). Preferred Shares are usually cumulative (in other words, if a dividend is passed in a certain year, the right for priority is reserved until the payment of a dividend, for all the years in which no dividend was paid) and non-participating (in other words, the holders of preferred shares are not entitled to partake in dividends together with the holders of ordinary shares after they receive their preferred dividend). Preferred shares may be voting shares (in other words, they may confer on their holders a voting right) or may be awarded without an attached voting right.

  Investors in startups are usually issued preferred shares that are convertible into ordinary shares, either at the investor’s discretion or upon the occurrence of pre-determined events. Such shares are always voting shares, and they customarily entail priority upon liquidation or upon events deemed as liquidation, as well as other rights such as protection against dilution and a right to veto resolutions of the company. (See the section in the next post for the rights attached to convertible preferred shares received by venture capitalists.)

• Stock Options— An option is a right to buy (call option) or sell (put option) a certain asset, for the exercise price, in a pre-determined period. When the option holder wants to exercise it, he pays the exercise price to the issuer of the option and receives title to the asset.

  As far as startups are concerned, this is usually a right to buy a new share that is issued to the holder of the exercised option. This type of option is referred to as a warrant, mainly in order to distinguish it from other options that are based on monetary clearing, rather than by the issuance of new stocks. Such options are allotted to investors in many rounds of financing, as well as to the employees of the company.

• Bonds— These are securities that oblige the issuer to pay the holder pre-determined amounts on pre-fixed dates, or upon the occurrence of certain events. An issuance of a bond (or debenture) is, in fact, a loan that is taken from the buyer of the bond.

  The basic distinction is between a straight bond, on which interest is payable on pre-determined dates, and a zero coupon, on which no interest is paid but which is sold at a price lower than its par value. A bond can be secured (when the payment of the debt is guaranteed by certain assets that serve as collateral) or unsecured. The quality of the collateral, coupled with the anticipated stability of the business issuing the bond, determine the risk involved in the bond, and hence its price. Bonds issued by startups often include an option to convert the bonds into shares according to a pre-determined conversion ratio (convertible bonds).

taken from; From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital

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