Copyright 2015 by the Acton School of Business. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without the written permission of Acton School of Business. This curriculum is used in its entirety at the Acton School of Business, based in Austin, Texas, an intense one year program taught exclusively by successful entrepreneurs. To learn more, visit www.actonmba.org. 02/2015

The Cash and Valuation Framework Plus Cash Flow Modeling and Valuation Tools Introduction The Cash and Valuation Framework will help you ask the right financial questions in the right order to make the right investment, operating, and financing decisions that make your firm and your ownership in it as valuable as possible. The C&V framework will also help you choose which cash flow modeling and valuation tools to use to answer the financial question at hand. The overarching question the C&V framework is designed to answer is: Are you making investment, operational, and financial decisions that maximize the value of the firm and your equity?

The Cash & Valuation Framework

The Framework is broken into two major parts:

• Adding value to your business; and • Knowing when to sell.

Adding value to your business is further broken into the three stages:

• Making incremental investments; • Creating a more complex business model; and • Adding financing.

For each section of the C&V framework, there are cash flow modeling and valuation tools that will allow you to make better financial decisions. You’ll also need an understanding of financial statements, the reporting tool that accountants use to compare the value of one firm and its equity to another, using Generally Accepted Accounting Principles to standardize reporting.

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In a way, the progression of the C&V framework mirrors the evolution of a business:

As an entrepreneur, you’ll first make sunk investments for assets like machinery and commitments to fixed period costs like rent to get the business started. You will be eager to reach cash flow breakeven and payout as soon as possible.

As the business grows, you may offer customer credit or add inventories or make new expenditures to grow, all of which create a more complex business model.

Once the business model is proven, you may want to add debt to lower your cost of capital;

If you have outside investors or run a public company, you’ll need to use financial statements to report economic reality to outsiders; and

One day, if someone offers you a market price that’s more than you believe the business is worth, you may sell the business.

Some corporate CEO’s act as if once a company is public, all that matters is financial reporting and their company’s stock price. Nothing is further from the truth. A leader who does not understand the basic unit economics of his or her firm is on the road to ruin. That’s why any financial analysis should begin with the first step of the C&V framework. The Right Tool For the Right Question (Or Why If You Have a Hammer, the Whole World Is Not A Nail) Many entrepreneurs make mistakes in accounting and finance because they fail to ask the right questions. All too often when this happens, an entrepreneur becomes lost in accounting or financial jargon or blindly applies a financial template. Similarly, some entrepreneurs learn to use one financial tool and try to use that one tool no matter what question has been asked or what data are available. At each stage in the growth of a business, an entrepreneur must ask critical questions to make sure they are making the right investment, operational, and financing decisions. To answer these questions, you need to use the right tools. There are two types of tools you’ll need along the way: cash flow modeling tools and valuation tools. Cash Flow Modeling Tools The most powerful way to visualize the attractiveness of a business is to project the amount of cold, hard cash the business will produce over time. An entrepreneur calls these cash flows. At each stage of the growth of a business, you will learn how to project potential future cash flows for every possible scenario at each decision point. Comparing these cash flow curves will help you make the best decisions for your business. Valuation Tools Cash flows show you the story of the business’s cash over time. But to give you the full picture of what’s happening in the business, you’ll want a way to quantify the value of your business—how much the business is worth to you. The valuation tools in the C&V Framework allow you to calculate the value of a given business opportunity. But value can be a difficult thing to define.

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Defining Value Value is measured inside the mind of an individual as he or she weighs the attractiveness of one item, at a particular point in time, against another.1 This means valuation is a subjective measure. For businesses, value is made up of three things: The cash I must invest and hope to gain from an opportunity, the amount of risk that opportunity carries with it, and the time it will take to get my investment back and see the rewards.

Value = Cash + Risk + Time

In other words, value depends on the size of the required investment, the timing and magnitude of the free cash flows you expect the business to produce, and the likelihood you’ll actually see those free cash flows. With the C&V framework, you will learn tools that help you measure cash, risk, and time to create a valuation of your business. As your business becomes more complex, you will need to be more and more precise about how you calculate your valuations. If a business has multiple owners, or is using borrowed money to help pay for its operations, you’ll need different tools to measure the value of the business as a whole and the value of the business to you. Remember to pay attention to the information you’re seeking and to always match the right question with the right tool. There are four other basic rules to help guide you in your valuations. We call them Sahlman’s Four Rules of Cash (after Bill Sahlman, who defined them):

1) More cash is better than less cash. 2) Cash sooner is better than cash later. 3) Less-risky cash is better than more-risky cash. 4) Never run out of cash.

In running a firm, you will always face tradeoffs among more cash, cash sooner, less-risky cash, and the likelihood of running out of cash. Because every business is different, the only real way to judge the value of a firm is to compare one firm with another and make personal judgments about the projected cash flows and risks of each. Notice that we have been referring to the value of your business and not the price of your business. Intrinsic value (what the business is worth to you) and the market price (the amount it could fetch on the market) are not the same thing. When you sell or buy a business, value leaves the world of your mind and enters the world of the market. As soon as a business enters the market, the market sets a price on it. This price can be much higher or much lower than the intrinsic value of the business to you. Do not confuse market price with intrinsic value—an entrepreneur is always concerned with creating value in a business through investment and operating decisions, he or she only uses the market price to know when to sell.

1 In order to make goods and service easier to trade, we are accustomed to valuing products and services in terms of dollars or euros or yen. But this is just using a unit of currency as a yardstick to compare the value of one item to another.

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By modeling how much cash different scenarios will create, and the corresponding value of your business, you will decide whether or not to make specific investment, operational, and financing decisions. The questions, and the cash flow modeling and valuation techniques to answer them, build stage-by-stage as the business grows in complexity and maturity. Stage One: Am I Making the Right Incremental Investments?

Stage One concerns the basic economics of your business. In other words, do the potential profits of a venture justify the cash and time you have to put at risk in a venture? The questions you will ask at this stage: • How large a cash investment will you have at risk in the business? • How quickly will you reach breakeven free cash flows so you no longer have to feed the

business cash to keep it alive? • Once you reach critical mass, how long will it take to reach payout and recover your

investment? • Given the inevitable competition, how long will you be able to maintain profits and free cash

flows at a healthy level, and do the potential profits justify the time and money put at risk? The cash flow tools at this stage will be simple: basic Unit Economics—the investment you need to make and contribution for each unit sold; and Sahlman’s Rules of Cash—a simple set of questions to help balance tradeoffs among cash, risk, and time. Stage Two: Do You Have the Right Business Model?

In order to grow sales, you’ll often need to provide customer credit, add inventories, or make incremental investments that lead to a more complex business model. That means you’ll need to ask more questions and use more complex tools. The questions you will ask at this stage:

• Is the business simple (short cycle times, low variability, low capital intensity) or complex?

• As revenues grow, how quickly do profits and cash flows increase? Profits and cash flows from businesses with high operating leverage will soar once breakeven is reached, at least until more investments or fixed period costs are required to add capacity.

• What is limiting growth: high prices, a lack of customers, or a lack of capacity?

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• Do you have high margins and can you sustain them? • Do you need to invest a little or a lot of money in inventories, customer credit, or other

assets as revenues grow? If a lot, is this because of rapid growth in revenues or because of deteriorating operational effectiveness?

• Is the increased complexity worth the more volatile cash flows and loss of flexibility? • Is the intrinsic firm value more sensitive to changes in revenue, margins, discount rate, or

terminal value? In order to answer these questions, you’ll need more powerful cash flow modeling and valuation tools. The Free Cash Flow to the Firm (FCFF) tool will allow you to compare different scenarios of revenue, investments, and costs forecasts by visualizing how each decision will affect the amount of cash your business will create over time. Intrinsic Firm Value measures the value of the firm you have created, based on the FCFF discounted for the time value of money and risk. Warning: As your business grows, it will become increasingly difficult to identify the basic unit economics underlying the business. You will be tempted to ignore these fundamentals and move quickly toward ever-increasing complexity in the search of more growth. Don’t fall for it. The best opportunities start simple and stay simple. Remember to return and revisit the tools you started with. As you compare and contrast business models, you may begin to see patterns in the free cash flows that are created and begin to separate the characteristics that separate attractive from unattractive businesses. Below are some of the attributes that separate attractive business models from unattractive ones:

Business Models Attractive Unattractive

Many customers with an intense need and few substitutes

Few customers with little need

Simple: short supply, production, and distribution chains; stable demand

Complex: lengthy supply, production, and distribution chains; high variability in demand

High margins Low margins Quick payouts Long payouts Low asset intensity High upfront and working capital

investments High barriers to competitors Intense competition Bootstrapped or easily leveraged with non-recourse debt

High upfront and working capital investments

Intrinsic cash flows frequently overvalued by the market

Business is difficult to sell

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Stage Three: Will Adding Debt Increase the Value of the Firm to You?

Extraordinary opportunities have high margins and no need for large investments in fixed assets. This means their cash isn’t tied up in commitments like inventory, machinery, or credit. They generate positive free cash flows even if revenues are growing quickly and can be “bootstrapped” with a small amount of start-up capital and funded by cash it produces. In a business with lower margins and that requires frequent and large investments in working capital or fixed assets to grow, you may need to seek cash from other places to grow the business. If you do, you’ll have two options: rent the cash or buy it. Renting the cash means you borrow it for a determined period of time. This may mean pledging assets or cash flows as collateral in return for lower-cost debt financing.2 By using lower cost debt, you can disproportionately increase the returns to and the value of your share in the business. But will you have enough free cash flows to make the required debt payments? Unfortunately, the benefits of low-cost capital from debt are often offset by the increased risk of fixed repayment terms required by most creditors. Not only are creditors paid first—which means 100% of any shortfall comes out of the equity holders’ share of cash flows—but debtors can also seize a firm if it is unable to make these fixed payments. Your other option is to buy the cash through selling part of your stake, or equity, of the business. This, however, forfeits your right to the share of the extra free cash flows you sold. The questions you will ask at this stage:

• Will adding debt increase the value of your equity? • Is the value generated by the extra growth worth the cost of the money you are

borrowing? • Will you have enough free cash flow to make the required debt payments? • Does using debt create any valuable options? • Does your company generate high quality returns due to high margins, extremely

efficient use of assets, or high financial leverage? • Is the intrinsic equity value robust given changes in revenue, margins, discount rate, or

terminal value to take the risk of adding debt? The tools you will use for this stage will move from measuring the free cash flows and intrinsic value of the firm, to dividing the free cash flows and value between equity and debt holders, under a range of scenarios. Free Cash Flow to the Equity (FCFE) models show how much free cash flow is left over for equity holders after interest and principal payments to debtors have been paid. Running different revenue scenarios can show just how far revenue estimates can fall before a firm runs out of 2 The cost is lower because of a lower rate demanded by investors and a tax effect.

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cash. Intrinsic Equity Value, the value of the equity based on your free cash flow to the firm projections, is calculated by deducting the market value of the debt from the intrinsic firm value. Borrowing or selling cash can lower a firm’s cost of capital—and increase the firm’s value—only as long as fixed repayments don’t unduly increase the risk of bankruptcy. Stage Four: Is It Time to Sell?

As you are busy adding value to your business, a buyer may appear who is willing to pay far more than the intrinsic value you place on the firm’s free cash flows. That means it may be time to sell. The market price has no necessary connection with the actual value of your business. It is not a way to add value to a business. You can use it to compare the value of your business with what someone else would be willing to pay for it. Comparing your firm value with the market price will tell you when it might be time to sell. Warren Buffett once said: “In the short run, the markets are a voting machine; in the long run, markets are a weighing machine.” In the long run, cash flow (or the lack thereof) will convince the market to accurately value your company. But in the short run, fads and fears can sweep through markets and can cause vast short-term over (or under) valuations. If you get a sense that the market has become overly optimistic, your first task is to calculate the intrinsic value of the firm and its equity to you. That way, your calculations of value will not be influenced by aberrations in the market. Next, you’ll want to find public companies (or private companies that have recently sold stock) that are comparable to yours. “Comparable” means a similar size, with similar margins and a similar competitive position. Then you can compare different economic yardsticks to calculate if an auction of the company would bring a market price that exceeds the intrinsic firm and intrinsic equity values to the owners. Do you want to “buy low and sell high”? Then focus on starting or buying a business when market multiples are low and selling when they are high. The questions you will ask at this stage:

• Have you calculated an intrinsic value before entertaining offers? (You do not want your assumptions influenced by an “anchor price” offered by a seller.)

• Will the firm sell for more or less than its intrinsic value if it were sold at auction? • Are you launching when market multiples are low and selling when market multiples are

high? • Do you have a complete set of comparable companies? • Are your comparables comparable? • Does your valuation yardstick measure what counts?

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• Should you add or subtract anything to or from the intrinsic firm value because of your noncash personal wants and needs?

Your tools at this stage will be to search for comparable cash flow models of public companies and valuation yardsticks that match “apples to apples” in order to estimate the value of your firm and its equity to others in a competitive bidding war. Four Key Principles for the Cash and Valuation Course There are four key principles that will make this framework and its cash flow modeling and valuation tools more useful:

• Focus your analysis on counting real customers and tangible products. Act like a financial detective, using the questions and tools in this framework to decipher what is happening on the factory floor or within the sales force. Count products and customers. Learn to think of inventory not as a number on a balance sheet but envision it as piles of raw materials or semi-finished goods stacked on the factory floor. Imagine accounts receivable as individual IOUs written by customers.

• Always begin with adding value to one customer at a time.

Start every analysis by determining how you add value, one customer and one sale at a time. The early questions and tools in this framework work best for simple businesses, but they also are the critical first steps for analyzing a highly complex business. You must master the simple tools and skills first before moving to the more complex.

• Be clear about which question you are asking before you reach for a financial tool.

Often students will learn one financial tool and try to use it, no matter what the circumstances. The cash flow modeling and valuation tools presented in the course are each designed to answer specific questions. Do not choose an analytical tool until your goals and the question you are asking is crystal clear.

• Decide how much weight to put on historical data to drive forecasts.

Projections require data. You either can forecast results based on trends in historical data from financial statements or from a bottom-up projection based on the customers, processes, and expected competitive environment in your business (unit economics). Your approach will likely depend on the quality of the data you have and whether you expect imbedded trends to continue or change.

These four principles, the C&V framework questions, and the C&V cash flow modeling and valuation tools will help you analyze real-world cases until you develop the skills and intuition of a master entrepreneur.

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Scrutinizing the Data: Historical Financial Statements and Unit Economics The accuracy of your answers to the questions in this framework depends on your data. But the data an entrepreneur wants isn’t always the data he or she has. Each time you use data to answer a question, ask yourself: Is the data up to date? Is the data accurate? Is the data abundant?

Your knowledge of a business can come from two different places: deep, personal knowledge and historical financial statements. Historical financial statements, the statements a business self-reports to show how it’s doing financially, offer some help in understanding the underlying operations of a company. A savvy investor can use them like a detective to unearth what’s actually happening with the production and sales of the business. However, financial statements only describe the past and therefore make poor predictors of the future. The real entrepreneur understands a business at its most fundamental level—one customer at a time, with a deep, personal knowledge of the company and the industry. He knows what to expect from customers and competitors. He knows how sensitive profits are to changes in revenues and which business models tend to be the most successful. Each time you answer a question on the framework, ask yourself, where is the data coming from? Summary The main goal of the Cash & Valuation Framework is to help you make the firm and your equity in it as valuable as possible, by building an economic model for your business that is as attractive as possible and can be executed by you in the real world. The questions in the Cash & Valuation Framework and corresponding cash flow modeling and valuation tools are designed to help you make the difficult decisions that will make attractive businesses even better and help you avoid unattractive ones. Practice first on simpler businesses with simple and short supply chains, manufacturing cycles, distribution chains, and cash cycles. Be content at the start to use rules of thumb for the terminal values and discount rates needed to value your firm. As you gather more and more experience evaluating real companies under a variety of circumstances, you will not only develop your own intuition about the relative value of cash, risk, and time for different companies, in different situations, at different times, but also the skills to evaluate more-complex firms. Eventually you will have the skills, habits, and judgments of a master entrepreneur, knowing which tool to choose—depending on the question asked—and ready to make the right operational decisions to add value to your own company.

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