There are essential calculations for start-ups that all founders should know, but many don’t. Too many entrepreneurs have to learn the hard way that teaming innovation with hard work is no guarantee of start-up success. Staying across your finances and knowing the numbers your venture needs to reach and maintain are equally crucial. So, we’ve decided to pull back the curtain on nine financial formulae that will boost any start-up’s chances of success.
Money talk
Cash flow is king for any business, but especially for start-ups. They frequently experience capital shortfalls on the road to commercialisation, particularly when they’re in the early stages (pre-revenue) or about to scale up.
When it comes to cash flow, there are four sums you really need to master:[1]
1. Cash flow statement
cash from operating activities +(-) cash from investing activities +(-) cash from financing activities + beginning cash balance
Your cash flow statement is the financial cornerstone of your venture. Tally up all your cash inflows and outflows from your operating, investing and financing activities and add the total to your starting cash flow position.
This calculation shows you the cash on hand your business has for a set period, for example, a month, a quarter or a year. It covers the actual cash paid into and out of your business. So it paints a picture of how cash flows through your company. It doesn’t take into account outbound or inbound invoices that are in the works but haven’t been paid yet. But it can inform you, for example, whether your payment terms for customers are sustainable.
2. Free Cash Flow (FCF)
net income + depreciation/amortisation – change in working capital – capital expenditure
While your cash flow statement reveals how cash is flowing in and out of your business over a particular period, it doesn’t tell you how much disposable cash your company actually has. So, it doesn’t hit the mark in terms of allowing you to plan or budget. That’s where FCF comes in. Look up your company’s income statement and balance sheet, then plug in the numbers to complete the formula.
3. Operating Cash Flow
operating income + depreciation – taxes + change in working capital
If it’s pinpoint accuracy you need for your cash flow position, then operating cash flow (OCF) is the sum you’ve been looking for. FCF is useful when you need to know what cash you have on hand to spend in your business. But it doesn’t capture irregular or unplanned expenses that can crop up during day-to-day operations.
So, if you want to see your typical business cash flow, OCF is the calculus for you. It’s also the one banks, other lenders and investors such as venture capitalists (VCs) will want to look at.
You’ll need to add your operating income or earnings before interest and tax (EBIT) to add to your depreciation, tax and working capital figures to arrive at this number.
4. Cash flow forecast
beginning cash + projected cash inflows – projected cash outflows = ending cash
While FCF and OCF give you a snapshot of your current cash flow or cash flow over a period of time, they don’t look ahead. Knowing what’s around the corner for your cash flow position is essential. It can make or break your business. A cash flow forecast is a great way to get a handle on future cash flow. Fortunately, this crucial formula is also one of the easiest ones to calculate. Simply choose a future period, say the next 30, 60 or 90 days, take your current cash position, add your expected cash inflows and subtract your expected cash outflows to see your forecast.
5. Burn rate calculations
There’s an old saying, “..if you look after the pennies, the pounds will look after themselves” which pretty much sums up the benefits of the burn rate calculations. The insights you glean from burn rates will help you make meaningful decisions around company expenses and income.
The first thing you need to know about burn rates is that there are two types: the gross burn rate and the net burn rate. The gross burn rate tells you how much money your company is spending. The net burn rate includes your company’s revenue and reveals how much money you’re losing.
Gross burn rate:
expenses/number of months
You work out your gross burn rate by taking your total expenses and dividing them by the number of months they relate to.
Net burn rate:
(starting balance – ending balance)/number of months
You calculate your company’s net burn rate by deciding on a time period, e.g., one month, three months or six months. You deduct your company’s cash balance at the end of that period from your cash balance at the beginning, then divide that figure by the number of months during that time.
The longer the period you use to calculate your burn rates, the more accurate (and useful) they’ll be. And if you’re looking to calculate your runway (which every start-up should) then you’ll need to know your net burn rate first.
6. Runway length
Your runway is how long your start-up has before it runs out of cash. So, it’s a must-know calculation. Fortunately, working out your runway is pretty straightforward.
Runway:
cash balance/net burn rate = cash runway
Simply take your cash balance and divide it by your net burn rate. When it comes to how long your start-up’s runway should be, there’s no precise length because it’s influenced by your business stage and other factors. These include how long it will take your start-up to turn a profit or if you’re planning to exit. However, most experts recommend aiming for an 18-month runway.
7. Valuation
If you’re looking to attract investors, having your cash position, burn rate and runway length down pat is great. But you also need to know your company’s valuation. Valuing a start-up is fiendishly complex: too complex for us to do the topic justice here. There are a myriad of ways to go about it. So, we’ve selected three main methods to help you arrive at your start-up’s valuation. The mode you choose depends on the stage your start-up has reached and its industry sector.[2]
Earnings before interest, tax, depreciation and amortisation
If your start-up is further along and not only generating revenue but making profits, the earnings before interest, tax, depreciation and amortisation (EBITDA) valuation method could be just the ticket. It involves taking the EBITDA for the most recent financial year and then using a multiple to arrive at a valuation. Multiples tend to vary between sectors, so they can range anywhere from 0.75 to 14 times your start-up’s EBITDA.[3]
EBITDA valuation
EBITDA x industry-based multiple = start-up valuation
Start-ups with a more traditional business model are the type of business that tends to use an EBITDA valuation. Whereas high-growth start-ups with a lot of expenses, e.g., software ventures, are better off using the revenue and growth valuation method.
Revenue and growth
Revenue and growth are used for those big spending, high revenue, high-growth start-ups that don’t yet have an attractive EBITDA. Take your start-up’s revenue and multiply it by a multiple based on your growth rate. This multiple is negotiated between you, your advisers and your potential investors. The higher your growth rate, the higher the multiple. So start-ups with high growth rates tend to attract higher valuations.
For example, a start-up with 40% annual growth could receive a multiple between 6 and 10, whereas a venture with 10% growth may only command a multiple of 1 or 2.[4]
Revenue and growth valuation
revenue x growth-based multiple = start-up valuation
Pre-revenue valuation
If your start-up has neither profits nor revenue, it can be challenging to arrive at a valuation. You can use the scorecard method developed by Angel Investor Bill Payne to rate your start-up based on the weighted averages of factors such as your founding team’s capability, the size of the opportunity and the competitive landscape.[5] Or you can try to generate income that will help you work towards a more tangible valuation for your venture instead. Convertible notes are one option. Another avenue worth exploring is a simple agreement for future equity (SAFE).
A convertible note is a simple short-term loan. You can either repay the lender with capital and interest or by converting the convertible note into shares once your start-up attains a pre-agreed milestone. Convertible notes don’t usually come with controlling rights. So, they let you avoid early dilution and leave the path clear for future investors, including VCs.
SAFE agreements were developed with early-stage start-ups in mind by Y Combinator. While they share some similarities with convertible notes, they have the advantage that they’re not loans and don’t rack up interest.
8. Dilution
Sooner or later, your start-up will seek investors. And you’ll exchange an ownership stake in your venture for capital. When that time arrives, it’s crucial to have a handle on dilution for each and every funding round.
Dilution calculation formula
existing shares – new shares/existing shares x 100 = dilution percentage[6]
There’s no hard and fast rule about how much equity a founder should hold onto after attracting VC funding. But if you can manage to keep 15-25% of your start-up, that’s generally considered to be an optimal outcome.[7]
9. Gearing
One of the most important gearing ratios for start-ups is the debt-equity ratio. This ratio tells you how much debt your business has compared to equity. Gearing ratios tend to vary between industries. So, before you pass judgement on your venture’s debt-equity ratio, it’s crucial to benchmark against what’s typical for your sector.
Debt-equity ratio
Total debt/total equity = debt-equity ratio
As a rule of thumb, the higher your company’s debt-equity ratio, the greater your reliance on debt compared to equity and the greater your vulnerability to economic headwinds. Many lenders will consider your start-up’s debt-equity ratio before approving loans and other financing products.
** Bonus Calculation
If your start-up is one with R&D, a key calculation you’ll want to know is the R&D Tax Incentive (R&DTI) refund. For every one dollar you spend on eligible R&D you could get 43.5% back in the form of a tax refund.
And better yet, our Radium Advance product lets you access up to 80% of your start-up’s expected R&DTI refund early and as often as your business needs. Use the Radium Advance calculator to find out how much you could access or reach out to our team of helpful experts to find out more.
[1] How to calculate cash flow: 3 cash flow formulas, calculations, and examples. 2022. [ONLINE] Available at: https://www.waveapps.com/blog/cash-flow-formula.
[2] Understanding the common startup valuation methods. 2023. Understanding the common startup valuation methods. [ONLINE] Available at: https://www.logicboostlabs.com/blog/2020/02/17/calculating-valuation-for-your-startup.
[3] Business valuation multiples by industry | Nash Advisory. 2022. Business valuation multiples by industry | Nash Advisory. [ONLINE] Available at: https://www.nashadvisory.com.au/resource-centre/valuing-business-using-the-multiples-approach.
[4] Understanding the common startup valuation methods. 2023. Understanding the common startup valuation methods. [ONLINE] Available at: https://www.logicboostlabs.com/blog/2020/02/17/calculating-valuation-for-your-startup.
[5] Aamir Qutub. 2023. Pre-revenue Startup Valuation Calculator. [ONLINE] Available at: https://enterprisemonkey.com.au/startup-valuation-calculator/.
[6] Wall Street Mojo. 2023. https://www.wallstreetmojo.com/equity-dilution/. [ONLINE] Available at: https://www.wallstreetmojo.com.
[7] https://www.investopedia.com. 2022. Diluted Founders. [ONLINE] Available at: https://www.investopedia.com/terms/d/dilutedfounders.asp