 Namaskar, I'm Professor Devadeep Purukayastha from the Indian Institute of Technology, Bombay. Welcome to my course, Business Fundamental for Entrepreneurs, Part 1, Internal Operations. As part of the course, I'm very pleased to welcome Professor Umakan Jayaram, who is a very illustrious finance industry veteran to share a few modules. Professor Umakanth is an alum of IIT Bombay and he went on to do his MBA post which he has 30 years plus of industry experience in various aspects of finance. He has worked extensively in the banking industry, he has founded his own company, he has sold his own company and he serves now as a public interest board member at the Bombay Stock Exchange. So it is my pleasure to hand over to Professor Umakanth for his module. We now move on to focusing on finance. I would like to begin with reminding all our viewers on the core axioms of finance, as well as I'll take some time to actually explain as to how finance is different from accounting. And finally, it's important for founders to know what part of finance is actually most important for them to be fully aware of and what part of finance should necessarily be delegated to a CFO. So in this slide we are basically looking at all these three aspects. How is finance different from accounting? First of all, the focus of finance is not to actually depict the true and fair value picture of what has happened in the business. The focus is forward looking and it is for decision making for the managers. It is also for decision making for the investors. It could also be a decision making for creditors or lenders. In either one of these forms, finance basically is a view that is taken on the business using some tools on helping their decisions to be made. So typical decisions for managers is how much should I actually leverage debt into my business? What is the right level of debt? Second is how much can I grow? What should be my growth ambition? Third is what should be my target profitability? If I have to satisfy all my stakeholders and at the same time be able to sustain the growth. For the investor, the most obvious one is should I invest more or should I disinvest in this business? To answer that question you should know what is the value of this business in the views of the investor, the shareholder value. What is the outlook for shareholder value in the near future? For lenders, they want to know if the amount that they have lent to the business is going to get repaid on time and in full. So these are the kind of decisions that they are concerned with. And the tools that finance allows all their users are the ones of forecasting because it is forward information. The ones of building scenarios because the future is not known and you have to make some assumptions about the external market, about interest rates, about inflation, about supply demand and so on. About the riskiness of cash flows and profits and revenues and ultimately about valuations or the worth of the business. This is the focus of finance which is not necessarily the same focus of accounting. Having said that what are the basic principles, what are the axioms of finance? What are the tenets or the key principles on which our financial knowledge is derived? The first one, the most universal one is time value of money. The fact that a rupee or dollar received today is worth more than if it is received in future is well known. In fact, present value of a rupee as always should be in nominal terms lower than the future value as long as interest rates are positive. This is the first universal principle is intuitive and people really are aware of this. The entire world of investments as well as the world of finance rest on applying derived principles from time value of money. You will see further on how businesses are valued using what is known as a discounted cash flow. A discounted cash flow is also a later application of time value of money. The second principle is that of risk and it says that no incremental risk will be taken by anyone unless there is an expectation of commensurate return. This is the basis in which asset pricing models are based. Assets are priced because they actually generate cash flows and each of those cash flow profiles have different risks attached to them. Risk is defined as the variability in the cash flow and even the uncertainty of such a cash flow being really received. Anything adverse is considered to be a risk. Given a particular risky cash flow which has been factored into an investment decision, investors will expect to relate any future information on that level of risk. And if there is going to be more risk in the new information flowing through, their expectations on returns will be upsized even more. The general theorem here is risk follows return. As risk increases returns also expected returns also grow and this is the relationship in risk and return. The third principle of finance is that cash and not profit or accounting terms is key when you are actually evaluating a business whether you should invest or not. It is not the net income that matters as much as the cash flow because values of the assets, the bundle of assets, what a business comprises is nothing but the sum of the present value of cash flows generated over time. The other business axiom is slightly counterintuitive. This is not something that we really encounter within our daily life. In business it's only incremental cash flows that counts. If cash is not generated incrementally then it's getting used somewhere else. It is incremental cash flow that generates a value from time to time. The next one is about risk and it says that all risks are not equal. What do you mean by that? Certain risks have got the potential for getting hedged out or managing out. Give an example. If you have revenue risk arising from the sales to a particular type of customer or sales of particular type of product. Let's say that you are in the business of selling umbrellas. The risk of umbrellas being sold when there is going to be no rain or a poor monsoon is something that can be actually diversified or hedged out if you add another product which basically has a higher revenue outcome in precisely the same conditions. Suppose there is no rain but there is sunshine and if you are actually selling sunglasses as well then when the sunglasses unit is not making money you're probably making money out of umbrellas and when the umbrellas is not making money you're probably making money out of sunglasses. And this is an example of hedging of risk or diversifying risk. The statement being made here is some risks can be diversified such that the concentration of revenue here is being diversified whereas some risks just cannot be diversified and they are systemic in nature or systematic in nature. These risks are global macro risks. Right now a lot of talk is being made of how the global macro risk is impacting business worldwide. Geopolitical tensions or war is one example where business activity all around is subdued. This is not diversifiable. The last but most counterintuitive principle of finance is the curse of competitive markets. You see competition is the best thing that you have when understood that I love you to win and your business plan can be a winning business plan if it knows how to beat competition. That's right. But when you win, you actually show that you will be having making profits under a particular condition and your profit making potential becomes the real goal of new entrants. Others will also come in with a prospect of making profit such as yourself and as a result over a period of time the profit potential of your business will actually get subdued. So the price that innovation has to actually recover all of the cost of innovation in time before the business gets commoditized and before the business basically encounters a competitive intensity where profit pools are actually going to shrink. This is what the curse means. It works other way around as well. When the prospects of an industry is actually falling what really will happen is the least profitable will exit the business and then the next least profitable will also exit the business and then everybody else from below. And as more exits take place the competitive intensity in that business is actually reduced and the profit pools of the remaining incumbents actually increase. So competition works on both ways. It tends to actually subdue the profitable at the initial stages and it also tends to enhance the remnants when consolidation takes place and that's the principle that is being mentioned here. These are some of the main axioms of finance which we should always be aware of. Surely business owners should be aware of all this because they can then interpret the decisions which are recommended by the CFOs or by they themselves can suggest the right type of decisions to be made given a particular situation based on their understanding of these axioms. The final point that we need to know is how much of this should the funders completely be fully aware of. The early start-up phase at least unit cost economics is something that the founder needs to be aware of. It allows him to analyze operating revenue, operating expenses and take decisions that drive the business towards profitability at the soonest. It allows him to optimize his expenditure and actually make value-accurative decisions. Risk management is the other area which as the business scales up, a founder should be more and more aware. This comes from the principle of all risks not being equal to diversify, to actually award revenue concentration to de-risk something called operating leverage. Operating leverage is nothing but the proportion of the total cost which is actually fixed in nature. When this ratio is very high, it happens to be that the sensitivity of operating profits to a bidder to changes in sales is far more acute and one has to de-risk this by actually taking several different strategic decisions in such a way that you actually reduce the fixed cost percentage of total cost. Outsourcing is one such decision. De-risking financial leverage is basically bringing down the leverage or the debt-to-equity ratio of a business. The debt-to-equity ratio being high basically puts a stress on meeting the obligations and borrowings during times which are difficult, down times. And it is the actual sensitivity of interest-paying potential to actual profits. These three are the main areas that owners need to actually decide on as the business turns around and is in the growth mode and definitely more compellingly more so when the businesses are scaled up. Finally, some aspects of the financial planning should come straight from the top. When you're an early-stage company, cash flows, forecasting cash flows is all about how much of a tight leash you can put on and controls you can put on expenditures. This has to be coming from the top. Also, how can you derive revenues faster and cash fast from the revenues by taking decisions on credits to the customers, discounts to the customers, by selling down accounts receivables. These are all the various means that you can use to actually increase your cash flow profile. The ability to build scenarios is very related to risk management. Scenario planning is a top management skill that leads to be learned because responses to these scenarios or decisions under certain scenarios are what will make you win, factoring riskiness into the cash flow profiles decisions that you take is an art that you'll actually learn through planning and through the results after the planning. And of course, you get better and better in terms of presenting plans to investors which are credible, which actually make you credible in the eyes of investors because of how you communicate the future and the financials in a predictable manner through guidelines that more or less get actualized over time. This is what we would say is a founder's learning journey in the areas of finance. He should not confuse himself with all the things that the CFO needs to do, but he should definitely own up on these two or three main things. That said, let's just look at the two main areas of financial planning in the early stage of the business. The question being asked here is why should founders be involved with planning? The reason why founders have been asking these questions is because they see a lot of challenge in their data planning process. First of all, making a plan, estimating numbers is not an accurate process. No one can actually be able to estimate cost and expenses accurately at all times. So there's a level of ambiguity there. There's a level of error that's built into the process. So why should I do something that is inherently inaccurate? The second reason why founders change the planning process is, especially early startup founders, is that venture capitalists and those investors who they talk to in the early stage seldom take their plans at face value. They seldom accept them. They sometimes read them, but they don't seem to pay much attention to the plans per se. This is a fact. The third reason why founders find it difficult to spend time on planning is because they've got other things to do, which seems to be more important, like meet the next customer or make those new alliance with a partner or to actually manage employees or to actually develop the product itself. These are the areas that they're more comfortable with, and they don't see the immediate bang in terms of setting down and scroging all kinds of numbers to actually come up with a business plan. The last one is eventually all plans look like the same. That's true because all that you see from startups is nothing but this figure, an acoustic curve. So if everything remains more or less the same and you're hitting at the same, why do them? All we need to do is tell them as to what goes behind the plan. These are all valid arguments, but the main purpose of planning is not to see that as an end in itself. The plan itself does not actually derive any benefit on its own, but it's a means. It's a means of clarifying the assumptions that you have on your business that you take towards various issues on generating revenue, on making expenditures, the kind of compromises and trade-offs that you would make, and the kind of product that you want to build that whether it's going to be a costly one or it's going to be the one that is acceptable to your customers, but at very low cost, and so on and so forth. It's also a means to build credibility that you have thought through the situation. You look at a conservative if not a realistic view of what the outlook could be. It's very easy for a founder because he's passionate about his product to be actually blindsided of the outcomes and to actually overstate and overestimate the success of his business. A credible owner is the one who actually leaves enough room for outcomes that may not be as bright as he may think it will. In fact, most owners and investors deal with the future with a certain amount of risk. To them, risk is the ability to afford adverse outcomes, afford losses, and this is the level of losses that they can afford. If the owner and the investor both agree on common assumptions including this assumption is the level of loss that you can actually afford for a given point of time, it makes things a lot more easier. We're in the same path of progress towards a profitable outcome which is what they're all looking for. The final goal is to reach there where you are actually going to succeed in the marketplace and be extremely profitable. So planning is not to be seen as an end in itself but more as a means to build credibility, agree on common assumptions, and communicate effectively on how the business is going to grow and what path it is going to take towards profitability. It's important here to know that planning is more for the owner's use itself for setting internal performance goals and setting goals for himself. The secondary use is to share the plan with a given context and a goal with an audience in mind. This sharing process is different based on which stage of business your startup is in. If your startup is in the pre-revenue stage all you want to be talking about from a finance perspective is cash flow projection. How will I manage cash flow? How will I generate it well? How will I manage my burn rate? What is the kind of runway that I will be having and how do I manage when my runway becomes thinner and thinner? What is the number of months I actually have before I raise my next round and how many rounds have I raised with adequate time in hand? What's the history that I have? This is what is the context of pre-revenue business and here the objective has always been on product development, MVP, product market fit and getting the first customers or beta. In this entire journey cash is being burned and if you are able to actually present a good history of having adequate cash to meet all the objectives and having met all those objectives in the first two, three, four, five challenging stages it's quite likely that you can actually move forward very comfortably. That's the context for the first. Early revenue is taking off on the first it's about revenue forecasting you got your first few clients how much can you actually keep growing and getting revenue from those clients you can use that for recurring revenue MRR or ARR, number of customers one, lifetime value of the customers customer acquisition cost and all of that. It's only when you actually get into early growth which is you're actually looking at somewhere here where you're very, very close to turning around and then from now on you can either take a trajectory which is deep like this or it can go like this. That time you need to start looking at high-level budgets top-down budgets based on how much can you seize from the market how quickly can you get more customers on board how quickly can you grow your revenues how much can you control your cost how much can you actually get on to an engine of being operating margin positive and sustainable growth. Sustainable growth is further growth comes from internal cash generation and not from external cash generation if you actually overcome this challenge as well and reach till here you become a stable business you now actually have to no longer a single owner or few owners founded based company you become a decentralized business you probably have a management structure in place you probably have a board of directors in place you have a formal process of operational planning which is basically a revenue plan an expenditure plan a apex plan an expenses plan R&D plan and so on and so forth new products introduction all of that is done by different age different parts of the organization by different owners of the plan and they get consolidated and presented to a senior membership board the whole context of planning and finance changes once you become a high-growth company and once you become a company of scale the most mature stage of planning comes in when you use dynamic planning or scenario based approaches what if sense and response roll forward planning so on and so forth this happens when your business is really taken off but for early startups we just need to understand the context of cash flow management of revenue growth management and of a high level budget and if you meet these three stages pretty well then you know that your business is in good shape having said that let's take a good look at how to do a top-down plan what are the ways in which you actually look at it the first ones are very easy and we talked about it before we have a tight niche and a good view on cash flow management the second one is about revenue sales funnel it starts from a top-down approach starts from estimating of market size we have a term called serviceable operating market and to look at your potential to actually win market share from competition and how you will grow from a particular base case of market share to a future state and establishing the revenue growth that's going to come out of this process this is a top-down approach the bottom-up approach is looking at the assets and the business that you have right now and the track record what did you do last year what is the incremental increase in resources that you can apply to your activity this year and how much can you stretch work-forward basis you can actually look at the trend of customer acquisition costs that you are actually incurring and whether your targets that you can reasonably achieve will be based on determined by your CAC how much resources can you raise to further acquire an additional bunch of new clients you can look at the conversion ratio of new prospects to clients you can determine your budget finally CAC will give you the budget to a client and the conversion rate will give you the budget for all prospects and finally you can project the customer growth so doing both the exercise of top-down and bottom-up and right-sizing you start from there, go down and then re-trade going up it is the way in which revenue budgets are finalized it's also called the sales funnel approach when it comes to cost it's important to actually understand the basic types of costs that you have in a business you have costs which can be defined as either one time or recurring a one-time cost is a sunk cost a recurring cost is repetitive in nature advertising can be a repetitive cost a one-time cost can be digital transformation or setting up servers and so on it can be also classified as essential cost and optional cost what is nice to have and what is a must-have in terms of resources it can be actually classified as fixed and variable and we saw that before fixed cost are those that will be incurred no matter how much volume of output is actually realized by the firm and variable cost directly changes with the level of output the second thing about cost is not all costs are expenses expenses costs can be booked as expenses when you get a tax break such expenses will reduce your taxable income otherwise they are non-allowable expenses which will actually drain down your profitability but certain cost can also be booked as assets I'll give you an example of a cost that can be booked as an asset suppose you hire 20 developmental engineers to actually build a transaction system that uses AI and content management inputs to actually make recommendations this whole project which may be about say 200 manuals can be budgeted for a particular level value say 10 lakhs or 20 lakhs and can be expended out in the year as an expense in certain cases this can be capitalized and amortized over the many years of benefits that such a content management system will give to the business if you capitalize it it becomes an asset which gets amortized and if you expand it it becomes an expense that said research shows that for a typical tech start-up specially from India which are all consumer start-ups with services concepts the start-up cost breakdown is as follows 25 rupees to 100 is actually spent on application development either a website or an app that is a mobile app 25 to 100 equal amount is spent on payroll 13 rupees to 100 is spent on advertising and amongst all the businesses that are probably mixed between products businesses as well as services business the level of inventories to your cost structure is about 11 rupees to 100 the rest of all gets distributed between rent, utilities, equipment supplies consultants, market research and insurance in other words the main cost items for set-ups are tech start-ups expenses marketing expenses office space expenses payrolls do you have to professional services and you can optimize this a lot and other expenses this is again so if you have to look at dimension of nice to have this can be a nice to have this can be a nice to have the rest of payroll is must office space is probably must or maybe nice to have also in current context marketing is must and tech is must you can take the choice as to whether you want to actually upfront them in terms of one time or you want to take it as a recurring expense and also in terms of expenditure whether you want to book it as an expense or you want to book it as an asset but having taken those choices you pretty much get what your initial set-up expenses is afterwards you have to actually take benefit of the unit cost economics to look at how your income statement will look in terms of unit revenue unit cost variable unit cost fixed which comes from here and operating profits you probably will come to something like this your revenue model for a business if it is coming from sale of products sale of services sale of people that is billable people or billable people output and subscriptions then you can actually make estimates on an operating basis which gets translated into revenue lines or the top four revenue lines three years this will constitute your total revenue forecast the forecast is will have to be sensed in terms of a sense check in terms of growth whether such a growth is really achievable in this case 38% and 47% growth generally we answer in the context of which industry segment you are in what is the state of the industry what are others doing are you replacing is there a real compelling reason why your business is going to succeed while others don't and so on what is the level of innovation that you have what is the compelling proposition that you have in your business the rate expenses are the ones that we defined which are directly attributable to the output and comes as cost of goods sold or cost of sales which is an exchange offering in the financial markets this happens to be very very low the contribution margins are very high gross margins and contribution margins are very high and as a result of which this business is sure to succeed in fact it's unheard of in the common place to have such high margins maybe only Microsoft seems to have such margins but if you have a prospective balance or income statement like this you are surely going to be a unicorn if you have to look at it in the real context you see that there are some below the line items you see that there are things like other variable cost which you are not accounted for in the direct expenses so it is prudent for you to add them back and maybe then your margins will come down but in this case it comes down only marginally in this case it will probably come down to about 50% which is still a very good prospect but once you actually did it you can actually start looking at different scenarios what of such variable cost increased by 10% what if total revenues fall by 10% or to 20% what if both happen at the same time you can build scenarios and ask a lot of what of questions and then come up with different versions of your income forecast you can put in weights for each of these versions based on what is the more probable odds that such a situation will happen and then you come up with what is known as sensitivity analysis and expectation value for both revenues expenses and operating income this is the level of analysis that you would like to do when you are actually forecasting your business forward as you would notice all of this are terms which are accounting terms revenues and accounting term expenses is also an accounting term even more so because it is not equal to cash certain expenses like depreciation is non-cash so accruals change the cash profile of the expense prepaid and items also change the cash profile of expenses so these are accounting forecast we have to convert this accounting forecast into cash flow forecast because of our understanding of cash flow statements this can be done pretty easily all that we are doing is take our line of operating profits add back the non-cash expenses such as depreciation and amortization and reduce tax because tax has to be paid as a cash tax keep a reserve for non-discretionary capital expenditure that your business will always have to incur in order to remain alive and keep another reserve for changes in net working capital current assets minus current liabilities the level of working investments that your business needs and then you are alive at a level called the free cash flows this is the free cash flows that the business can reasonably expected to generate without taking into account any external debt because you taken about all of the debt effects on the business and this free cash flow profile is what is determined will determine the value of the business such key cash flow streams are now discounted using the time value of money time value money is nothing but the present value is equal to the future value divided by the one plus present value multiplied by the discount rate is equal to the future value therefore present value is nothing but the future value divided by the discount rate and time and this discount rate is determined by the opportunity cost for an investor to actually use this money and put it elsewhere and get a return which is going to forego actually taking decision of investing in your business this is called the cost of capital cost of capital is nothing but an opportunity cost the investor is making by taking a decision investing in your business there are sophisticated methods of actually determining what the discount rate really is for a particular business and its profile of cash revenues and its profile of equity financing but that's outside of the scope of our discussion today but just if consider that you know the discount rate is given as say 15% this being reasonable expectation of investors in Indian market in this case the internal rate of return of this cash flow profile is 22% which is far when excess of 15% and therefore this is actually a reasonable business there are other calculations that is possible based on the capital tables or the cost structure tables that the business is sitting on and that's again outside the scope of the discussion today but say when except all of this we do know that this is a business that can give a very good return to shareholders and therefore it's valuable now comes to the question as to how do we value this business our standard business which has got cash flow streams that can be determined very easily is valued by discounted cash flow which is actually the enterprise value which is a PV of all of this cash flows summated the summation of all the present value of cash flows is equal to the value of the business if you minus the debt value then you come to the equity value this is in rupees or dollar figures if you divided by the number of outstanding shares those who are claiming their ownership rights jointly and on to the business then you will get the value per share this is called intrinsic value per share and in this case it's calculated to be 14 rupees this is the DCF value but how do startups which do not have a revenue profile they don't have a single dollar or rupee of revenue how do they value them what is the practice in order to answer this question