Project at a Glance:
In late 2016, I was hired to build a dynamic financial modeling tool for Modern Macramé, a fast-growing, independent workshop and retail company in Portland, Oregon. In conjunction, I was tasked to write an executive summary pitch deck, with the possible goal of securing seed capital from an angel investor. The work entailed understanding the space, plotting revenue and expense for six separate revenue streams, calculating the shape of seasonality, budgeting balances by month for three years, preparing an income statement, and determining a valuation.
Founded in 2015 by design consultant and artist Emily Katz, Modern Macramé established itself as a hot brand for artisanal macramé home goods. Her work cultivated a highly devoted following (142k followers on Instagram) without spending a cent on marketing. Having already proven itself as a viable, sustainable, and profitable company, Modern Macramé felt ready to scale up and Emily, an old friend from high school, reached out for help. At that point I had successfully applied the same modeling process to startups in a number of different industries but never one with so many very different revenue streams. That's the thing about Emily, she always has ten or more business ideas on deck and, remarkably, all of them are good. I actually think she's the most natural and joyful entrepreneur I've ever met. From a business modeling perspective, it's a lot to keep up with.
Emily ultimately decided not to pursue the raise at the time but says she may end up taking it up again. Regardless, I'm proud of this work and the model is sound. I have NDAs with all of my clients (I insist on it) but it makes it hard to share some of the work I do. I wrote to Emily and asked if she would release me from the NDA I had signed and she generously agreed. Thus I'm able to share a detailed look at the how I visualize the gears of a company and how I present it to investors.
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During a series of client interviews, I began to understand how Modern Macramé was built, functioned, and where it wanted to go. The main problem was that they were beginning to get more business than they could handle, which is such a good problem. So they wanted to scale up, to capture more of that excess business and leave less money on the table. Modern Macramé needed to add personnel, capacity, new revenue streams, and online volume and new that the quickest way to get there was an initial injection of funds.
Aside from understanding the story and posture of the company so as to craft pitch messaging effectively, the most important aspect of this initial interview is identifying the most basic monetary unit. For a car rental company, it would be a day that a car is on rent. For a restaurant, it would be the income and price of an average dinner. For a brewery, it would be an ounce of beer. In the case of Modern Macramé, it was a foot of rope, as rope was used in all of its verticals, from workshops, to kits, to commissions, and so on. Once the basic unit is identified, everything thing else can be extrapolated from it.
Using a calendar made on Google Sheets, I planned out the project. It was scheduled to take about a month and the first step was researching the existing business and the market place in general (to look for upside, possible capture, competition, and differentiation). Then I had to build the model, starting from the highest level and drilling down in detail. Then I needed to write an explanation / defense of the logic, assumptions, and conclusions, a document I've found to be highly effective with investors. Lastly, I needed to create an Executive Summary which, at this early stage, would serve in lieu of an full pitch deck, and present the results to the principals at Modern Macramé.
I wasn't exactly sure how to research this market. Macramé was huge in the 70's but faded to the point that a resurrected craft company like Modern Macramé had few direct competitors. There were a couple similar companies in other countries but with no U.S. distribution. Most similar products such as DIY macrame kits were offered by small, individual sellers on Etsy. So I decided to focus on "handmade" + "eccommerce" + "furniture" as a general space. What I found was highly encouraging.
“Consider the re-emergence of artisanal goods. No doubt you are aware of the explosion of the market – some call it a movement – in handcrafted products. At times, it seems, the borough of Brooklyn has become one giant artist colony, with everyone working on something—whiskey, woodworking tools, the reinvention of the egg cream—targeted to a small but impassioned fan-base.” – Harvard Business Review
The disruptive technologies that initially seemed to be leading to the demise legacy industries have now led to their dramatic reemergence. To illustrate this, look to the spectacular growth of Etsy, which reported a 34.3% year-over-year increase in EBITDA in 2015, and a 51.1% jump in the fourth quarter. Internet retailing has enabled artisans and makers to sell their goods to directly to niche consumers at low overheads that would have been impossible to match in the past. Due to these low overheads, low startup costs, and easier distribution, the Craft & Hobby Association estimates that the domestic craft industry currently represents at least $30 billion.
Growth in this sector shows no sign of slowing. Much of this increased demand is being driven by consumer perceptions of what “handmade” represents. In response to the negative implications of mass production, consumers yearn for a direct connection to the people who produce their goods. Consumers want to help small, independent producers.
Furthermore, consumers perceive that handmade goods are of higher quality. In May 2015, The Harris Poll asked respondents to what degree they believed the term “handmade/handcrafted” communicates that a product is high in quality. 23% responded that this “strongly communicates this” and 36% believed that this “somewhat communicates this.” Contemporary consumers look to handmade producers for ways to express individuality. They associate handcrafted goods with exclusivity. They want to be engaged by a narrative of what they buy and are increasingly demanding provenance. Few companies have done a better job than Modern Macrame of crafting individuality, engaging followers, projecting exclusivity, and communicating a narrative about the importance of product provenance.
Also, the underserved but exponential growth of E-commerce in this space put Modern Macramé in a great position to achieve growth. Recently, CIO published an examination of the fastest growing sectors of online sales entitled, “8 Ecommerce Categories That Will Be Hot.” Of those 8 categories, one was furniture and home décor, and another was handmade products and crafts. Modern Macramé is furniture and home décor that is also made by hand. It is simultaneously two of spaces expected to outperform the market as a whole.
“There are several indicators that point to handmade products and crafts as one of the biggest opportunities for ecommerce growth in 2016,” says Parag Mamnani, founder & CEO, Webgility, a provider of multichannel ecommerce solutions. “From Etsy [going public] to the recent launch of Amazon Handmade, this [should be] a great time for makers [in ecommerce].” - CIO
I've seen startup pitches that only include a static PDF of an Excel sheet. I'm not a fan of this. I prefer to create more of a tool, in which cells can have variable values so that investors can play with various assumptions to see how the model performs under a variety of conditions. They can see what the minimum values are for the company to break even as well as how much the company can scale under the most spectacularly successful circumstances. That sort of transparency is beneficial to gaining the trust of a funder who is being asked to commit hundreds of thousands or even millions of dollars. Furthermore, if the model is solid, it can serve as a benchmarking tool for the company principals once the model is in action on the ground. I describe it to clients as a very dry but vital video game which, if they play correctly, will earn them a lot of money.
In creating this tool, I start with a high-level overview of all types of revenue and add a variable for how much money is raised. I construct the entire model to show three years of operation. I've seen models that stretch out five or even ten years but a very smart business analyst once told me that if I was able to predict how a company will perform more than two or three years out, I should be making Warren Buffet money. It's just unreasonable to make assumptions that far into the future but I feel three years should be enough time for an ambitious startup to get to scale.
Next, I create an expenses page showing commitment of all funds for each year. I assume that these expenditures will equal the amount of capital the company has on hand - essentially that it will spend 100% of its money and bring in a profit of $0 at the end of the year. This means that all extra capital is directed back into the growth of the company. That's not to say that an owner wouldn't make money. Their salary, which can be generous, is included in expenses. Furthermore, it's assumed that they own a large segment of the shares in the company and, as growth is ratcheted up, so is the valuation of the company.
I should say that, while this is common practice for startups, it's a method about which I feel somewhat ambivalent. On the one hand, it's the quickest way to get a company to scale and shows investors the potential for good multipliers. Even huge companies like Amazon try to run right at perfect efficiency and zero profit so as to create value for stockholders. It's also super helpful for tax purposes. On the other hand, this strategy can lead to over-optimism and market bubbles, with companies not allowing enough runway and bottoming out before they get to scale. Sometimes, I think the old-school style of trying to make more money than a company spends and paying out profits at the end of the year is more sustainable for smaller companies. My compromise is to add a section called "Retained Earnings," which is money that is unspent but saved to get a company through seasonally lean months.
Each type of expenditure is determined in one of two ways. The first is that a value can be static. For example, a principal can decide that their annual salary for the year is going to be $75k. That value is entered and the percentage of expendable funds is calculated. The other way is that certain expenditures are entered in as a percentage of expendable funds and the monetary value is calculated. For example, a user can decide that 5% of total funds will be spent on marketing and the dollar amount is shown. Regardless, the total expenditures (including retained earnings) should equal the total amount of expendable capital.
After that, I drill down into each of the revenue streams from the first page, creating a calculator page for each of the ways in which the company makes money. For Modern Macramé, these included Rope, Kits, Readymade, Custom, Rentals, and Classes. Each of these was essentially their own business. Macramé rope could be purchased and then sold directly from the site. But a certain percentage of it would have to be left over from which to make DIY kits. Rope would have to be left over from that to create Readymade items for sale such as planter holders, hammocks, wall hangings, and so on. After that was done, there would still have to be enough rope to make custom orders, such as wedding tents and art projects for restaurants and hotels. Still, there would have to be enough rope to make items that could be rented and then there would still be left to use for classes and workshops. The values of each were fed into each of the other pages, showing us how much of various types of rope would need to be purchased each year and how much that footage would cost when purchased from China or domestically. The revenue from each of these pages was then fed into the high-level Revenue page.
Then I needed to determine the shape of seasonality for each of the verticals. So many startups make the mistake of only showing annual income, planning to have every month making the exact same amount. But when a few months of very slow sales aren't planned for, a company can easily run out of money and be unable to get to the profitable months. For example, rental car companies do so little business in February and March but, come the Summer months, might not have enough inventory to keep up with volume. I generally use the averages of several years from the U.S. Census Monthly Retail Trade Survey as a baseline. But that's retail as a whole and certainly some retail industries will do better in certain months than others. I could have derived a more detailed baseline but that would have cost the client a bundle in white paper fees. For Modern Macramé, the staff takes a vacation in July and there are no classes or workshops. It can also be expected that Readymades and Kits will sell better around Christmas and that wedding and hammock rentals will do much better in the Summer. If this was a true startup, rather than an already established brand, I'd also include a ramp up of values, expecting a bump of business at launch and then a slow increase of volume throughout the year as marketing exposure and word-of-mouth establishes a footprint.
Those seasonal values are then used to calculate the monthly cashflow. It's important to show investors that the company's bank account will never bottom out. Like revenue, some expenditures will change throughout the year while others will remain constant. Rent would stay constant. Salaries would remain constant. But a higher amount of the marketing budget would be spent at launch and then in conjunction with special sales throughout the year. Rope orders would only be made five times a year (as it's cheaper to purchase in bulk). Travel and entertainment would be variable. A constant value is set at 8.333% (1/12 of annual), while variable percentage expenditures can be entered manually but must equal 100% of annual when all months are added up. I also included a minimum balance figure, imported from the Expenses page, in which a principal can decide how many months of expenses they want to keep on hand. This is the monetary cushion the company needs to retain in order to survive the lean months. Also, if this was a true startup, I would include a section for pre-launch as the company is set up, a time when the company is spending money but not yet bringing it in.
The income statement is super simple, showing the calculation of EBITDA. Valuation is more of an art form and one at which I'm not an expert. Unlike the rest of the model, there's no "right" answer for value, as it's worth exactly as much as someone is willing to pay for it. This is my least favorite part of financial modeling because it's not really a logical determination and you can often only get the attention of investors by showing huge multiples, promising them a unicorn. I prefer to err on the side of transparency and being conservative and then beating expectations and, while these figures may not be inaccurate, I assuage my conscience by showing both a discounted and un-discounted multiple. I also compare to industry standards, which is easier for established industries, like grocery stores or bars or an auto body shop, and virtually impossible for completely novel technologies or innovative models. Modern Macramé was somewhere in between.
One challenge was the deluge of revenue verticals. A good piece of advice I've heard for startups is to one thing and to do it very well. A lack of focus brought about by trying to spin too many plates can be a red flag for investors. We got around this by highlighting the fact that everything was based on buying rope and using that single resource in a variety of ways. Secondly, we highlighted on the synergistic properties of each of the revenue streams - that workshops could drive kit sales, that rentals could drive custom commissions, and so on.
Another challenge was the exponential problems created by such an interwoven model. I huge number of variables feed into other parts of the tool, which in turn feed into other aspects of the model. This means that a single mistake in a single function sends a cascade of errors through every page of the model and it can take a long time to untangle the trail of a miscalculation from page to page to page. I recently went back through this model, looking for errors but it seems to be clean. What I always tell clients is if an investor finds a mistake, that's the investor you want - smart money that took the time to understand how the conclusions were derived and diligent enough to try to poke holes in the logic.
It was also a challenge to determine an accurate valuation. It could be that Modern Macrame is an online retailer, and the standard industry multiples should be used. Or it could be that Modern Macramé is closer in nature to a school or yoga studio. Or perhaps it's a wholesaler of rope or a rental company. It's possible to find comparable valuations for each vertical separately but, when combined, it's difficult to know how to value it. To some degree, I worked backward, knowing how much the company needed to get started and thought about what percentage of ownership that seemed to be worth, and then used that to figure out the value. This of course would have to be negotiated with an investor that bought into the pitch.
In the first model I ever created for Zootly, I found that there was an advantage to never having attended business school. Essentially, I was unable to bullshit. Because I wasn't steeped in the nomenclature, buzzwords, and popular memes of the business world, I couldn't use technical language to obfuscate the logic of my math or assumptions. This created a transparency that the investors, Ivy League business majors themselves, found refreshing. I also couldn't take anything for granted. If I didn't know what EBITDA was or its importance in determining value, I had to go online and read about it until it made sense to me. I had to teach myself how to calculate amortization and understand the rate at at which various startups should try to scale. Sometimes when an investor or analyst asks me a question, I have to directly ask, "what does that mean?" Every now and again, the investors wouldn't understand how to explain it themselves.
To make up for my rhetorical shortcomings, I had to rely on basic, conservative, defensible, and sound common sense. The fully flushed out description of that common sense is the Explanations document that I create for my models, in which I go through and explain every single line of every single page of the tool. It is godawfully boring work, even more boring to read, and sometimes takes me longer to write than the entire model itself. But by going through that exercise, I always find a couple mistakes to fix or a few functions I should add. Even though trying to get funding involves a degree of salesmanship, I think both the investors and the company are best served by being as honest as possible, laying all the cards on the table. In many cases, I find that good investors ask the hardest questions, which makes for a more perfect model. I'm always hoping they ask me a question I don't know the answer to because that's the only way I'll learn.
Furthermore, the Explanations document serves as a sort of user manual so that my clients can use it once the company is in business.
Note: Out of respect to the Modern Macramé's future plans to pursue funding, I've deleted the valuations page from these explanations.
In a pitch deck, I include an NDA, a Powerpoint presentation of the business (which an investor should be able to get through in 3-5 minutes), an Executive Summary from the principals that includes the ask, the full business model as a baseline (essentially the least amount of investment and smallest volume possible to be sustainable), the business model in the way we most expect the company to function, and the Explanations document. The idea is that the easy stuff comes up front and, if the proposal seems compelling, the potential investors can get deeper and deeper into the weeds. This is usually enough to generate a sit down and serves as a jumping off point for questions and negotiations.
My least favorite aspect is the stupidity of over-valuation. Every pitch says that a company is going to be the next Uber. It's rendered even more dumb because investors, analysts, and VCs all know that it's BS and that a startup probably won't be worth 30x in three years. But even though no one believes it, it's expected, partly to demonstrate that a company can scale rapidly if the volume materializes. Personally, I wish pitches were more conservative and more accurate as it would lead to less failed startups, less industry bubbles, fewer quick flips, more sustainable companies, and more long-term jobs for employees. Unreasonable expectations can be disastrous for young companies, especially as they transition from a small enterprise to a mid-level and then IPO.
I prefer to be as transparent as possible, admitting challenges up front, and trying to find money that can contribute intellectual capital alongside monetary capital. To that end, I always encourage investors to look for flaws, to try to poke holes in assumptions, and try to be as specific as possible as to how the company will make the money work. So far, every model I've made that has gotten a meeting has been fully subscribed.
From where Ms. Katz was at in her life and where Modern Macramé was situated, she did not ultimately decide to pursue funding at that time. This has happened a couple of times and it's always slightly sad. But I also think that clients learn a huge amount during the process of developing a model. Sometimes, it's because after understanding how much work and risk it will take to run their own business or grow it at this level, they decide to stay put. Only once, after creating a model, have I had to tell a client that the business isn't worth pursuing. But even in those cases, I often feel as though I've performed an important service, potentially saving my client a huge amount of money and even years of frustration.
Some of the smartest, most ambitious, most creative and industrious people I've ever met are intimidated by creating a model like this. They generally already know the answers but need help laying them out in the correct order and being encouraged to think through the details of how the company will work in practice. Going through this exercise helps teach an owner how to think strategically about their business practice and to turn it into a game that they can win. Starting a business is super scary but it's also one of the most beautiful and exciting things that happens in capitalism. While politicians often pay small businesses lip service, actually witnessing an idea go from the back of a napkin to a functioning office filled with new hires doing work that didn't exist before is staggeringly cool.
I do hope that Modern Macramé does decide to seek funding and scale up in the future because I know that this company could be massive. But to tell you the truth, the company is already killing it while 100% owned by the principals. Regardless, it was such a privilege to work with Emily and I'm so thankful to her that she's allowed me to share this model with you.