Getting Started

Much of the step-by-step information for completing the six primary elements of the financial model has been provided in the body of the chapter. However, the following section puts those six components into context and demonstrates how they are part of a larger approach to developing and validating a meaningful and reasonable financial model.

Develop Detailed Bottom-Up Financial Model

What to Cover

Once the innovator has a quick, high-level understanding of the company’s financials, it is necessary to create a more detailed financial model to ensure the accuracy and credibility of the directional information. In a “bottom-up” analysis, the individual parts of the financial model are developed in detail. Then the parts are linked together to form the final plan. Following the guidance and samples provided in the background section, the innovator can create the:

• Operating Plan – Key inputs to developing the operating plan include a solid understanding of the steps required to build the innovation, a detailed understanding of how the project will be regulated by the FDA (including the estimated length of the clinical trials), and knowledge about how the product will be sold. Important outputs from the operating plan are an understanding of when the first sale will occur and the estimated timing for other critical milestones that affect the overall financial model.
• Staffing Plan – Key inputs to developing the staffing plan include the operating plan and an understanding of the complexities associated with building the innovation. Pay close attention to the milestones and determine how many staff will be required to achieve each one. Additionally, think about the impact that each milestone will have on the company and its staffing levels as it moves forward.
• Market Model –Develop both a bottom-up and a top-down market model and then reconcile the two. In the bottom-up market model, identify: (1) the key metrics used to measure progress trained physicians, installed hospitals, etc.; (2) training times and requirements per trained physician (or other appropriate metrics); (3) time to ramp up and steady-state per trained physician; (4) target performance metrics per sales rep; (5) number of sales representatives that will achieve and maintain the target metrics.
• Cost Projections –To prepare cost projections, the staffing plan is an important input, along with competitive benchmarks for employee salary costs. The company must also consider how much manufacturing and non-manufacturing facilities space it will need, and should then get estimates about pricing from the local market. Equally important is developing a strong understanding of the raw materials costs associated with the product so that these can accurately be taken into account when developing the cost projections.
• Income Statement – The income statement provides a summary of the company’s anticipated financial condition. Be sure that the ratios (R&D/sales, SG&A/sales, etc.) are reasonable or it may be an immediate warning sign to investors that the entire financial model is faulty.
• Cash Flow Statement –Important inputs to the cash flow statement include the company’s most recent income statement, the number of projected employees, estimates of cash spent per employee, cash likely to be spent on equipment, and estimates of inventory required. The output of this statement is the cumulative cash the business will spend which can be translated into the amount of money the company needs to raise.

Where to Look

• Other Innovators – These individuals may be able to provide valuable anecdotal information about appropriate staffing levels, ratios, and costs, having previously faced similar financial decisions.
• Industry Consultants – Consultants in the field may also possess valuable information about common industry figures, such as salary benchmarks, facilities costs, and raw materials costs.
• Other Resources for Top-Down and Bottom-Up Market Modeling –
  • 2.4 Market Analysis
  • Hospital Compare – Includes Medicare data regarding the volume of procedures performed per hospital in the U.S.
  • Dartmouth Atlas of Health Care – Database that documents glaring variations in how medical resources are distributed and used in the U.S.
  • Procedure Files from Medicare

Identify Proxy Companies

What to Cover

Direct competitors typically make for the strongest comparables. However, sometimes meaningful historical comparables exist which are no longer in business. When direct comparables are not available, gradually relax the constraints to broaden the sample set of companies which can act as proxy companies. Start by identifying approximately 10 potential proxy companies and then narrow down this list to the one to four companies with the most relevant challenges and processes. Remember to focus on companies that have demonstrated success in execution.

Where to Look

• Yahoo Finance– Yahoo Finance aggregates the financial data of public companies. By looking up a known public competitor, a hyper-text link in the left-hand column leads to a web-page of “Competitors.”
• VentureXpert– The functionality of VentureXpert is now available through Thomson ONE on a subscription basis. This source provides data on mergers and acquisitions, initial public offerings (IPOs), and venture capital funding based on data from Securities Data Corporation. Users can search the database to find detailed information about private start-ups including funding, investors, and executives.
• VentureSource – Another subscription database that contains detailed information about private start-ups including funding, investors, and executives.
• Hoovers Online– A subscription database of product profiles for companies, which includes competitors.

Develop Proxy Company Analysis

What to Cover

Once appropriate proxy companies are identified, the next step is to analyze each one via a top-down assessment. Find operational information, including the company’s key milestones, and try to reconstruct its operating plan (see online Appendix 6.1.1 for a sample proxy company analysis) via a top-down analysis. In a top-down analysis, an overview of the model is developed based on available information. Then, each part is refined (with additional information and assumptions added) until the entire model can be validated. The data to search for are outlined below. Public companies can be excellent proxy companies for two reasons. First, achieving an IPO is a milestone in itself that indicates some degree of success and suggests that the company’s operations potentially are worth analyzing. The second reason is that a company prospectus can be a rich source for operational details. A prospectus (also known as an S-1 filing made to the Securities and Exchange Commission) is a document released by a company prior to launching an IPO in which it seeks to tell a meaningful story about its history and future prospects to prospective investors. In doing so, the company must describe its operating history in some detail. The prospectus will not lay out the company’s entire operating plan and will likely omit data regarding the company’s earlier years. However, it provides valuable information that may be used to piece together the company’s operating history.

• High Level Operating Plan – Timeline of key operating milestones.
• Financing Milestones – Timeline of major financing events.
• Clinical Trials History – Timeline of clinical trials including duration, location, and number of patients enrolled.
• Other Milestones – Additional milestones, such as sales and distribution agreements signed.
• Operating Costs and Staffing Levels – Historical operating expenses and staffing levels by employee type.
• Clinical Trials Costs – Estimate of cost per person of the clinical trials process.
• Cash Flow – Cumulative cash flows.
• Information Extracted from the Prospectus of Public Companies –
  • Management’s Discussion and Analysis of Financial Condition and Results of Operations – Among other information, this section provides a qualitative discussion of the company’s operational progress and key milestones achieved. It also comments on the changes in year-to-year financial results and provides some historical cash flow data. This financial information can be useful in determining how much a company had to spend in order to reach the milestones it achieved.
  • Business – This section provides a fairly rich description of the company’s business, including information about the market, targeted disease, products, strategy, clinical trials progress, sales and marketing, competitors, manufacturing, reimbursement, IP, government regulation, employees, facilities, and litigation. The clinical trial data in this section can help to determine the length and complexity of the clinical trials process, as well as any specific regulatory hurdles the company has faced. It may also detail the current number of employees, employee types, and facilities sizes.
  • Financial Section – This section, at the end of the document, provides detailed financial information, including the company’s balance sheet, income statement, and statement of cash flows. The number of years of historical data available in the prospectus will vary by company.

Where to Look

Information about private companies is more difficult to find that public ones. Venture capital databases (such as those listed below) can be useful for locating certain details, including the company founding date and information about funding rounds (e.g., number of rounds, money raised per round, selected post-money valuations). They will also provide non-specific indicators of a company’s stage at each round of funding (selected from among “early stage,” “late stage,” “expansion stage,” etc.). However, they are unlikely to offer detailed information about a company’s operating history, requiring the innovator to have to locate this data from other sources.

• VentureXpert
• VentureSource
• SEC Edgar Online– Provides online access to business and financial information, including SEC filings, for more than 30,000 global companies.
• Personal Networks – Contact individuals and experts in the field who may be able to share relevant information.
• Cold Contact –Consider contacting executives at the proxy companies to request information that has not yet been made publicly available. Recognize that there is certain information that these individuals will be more/less likely to share and prepare a set of appropriate questions that will result in additional knowledge, without overstepping the bounds of professionalism and privacy. Also consider what reasons these executives would have to help (or not) and prepare your request accordingly. At all times, it is critical to take an ethical, honest approach to this kind of data collection, particularly when dealing with potential competitors.

Compare and Rationalize Bottom-Up and Top-Down Approach

What to Cover

Once the proxy company analysis is complete, compare the results to the bottom-up financial model created in step 1 of the process. Identify where significant variance exists. Look for divergence in the following areas:

• Key milestones
• Clinical trial process
• Staffing levels
• Underlying cost assumptions
• Costs to reach each milestone
• Time to begin sales
• Time to profitability

Also consider if the financial model should be adjusted based on the learnings and observations from the proxy company analysis. Were additional risks or potential concerns identified that should be addressed in other parts of the business plan? Review all aspects of the business plan again and make adjustments (or seek additional input) before finalizing the document. Remember that this is an iterative process and the financial model will probably need to be refined several times before it is ready for review by potential investors.

Where to Look

Refer back to the working version of the business plan and financial model and data gathered from the proxy company analysis. The innovators should also reach out to members of their personal network with questions or concerns.