Management Case, Base Case and Worst Case

Early stage venture capital investing is not really a numbers oriented business.

Its much more important to have a feel for technology, markets, and people than numbers.

But there are times when numbers are important.

Two of the most important times you want to focus on numbers are:

– when you want to figure out what kind of returns you can expect for a particular investment
– when you want to figure out how long the cash you are investing will last

I’ve seen this done a bunch of ways over the years, but the methodology I like best is to do a three case analysis; management case, base case, and worst case.

I was taught this approach by the team at JP Morgan Partners with whom I worked very closely building and managing the Flatiron Partners portfolio.

When they do a buyout or growth equity financing, they get into the numbers in a big way and their three case analysis is incredibly detailed.

We always struggled a bit to map the buyout investment process to early stage venture capital and sometimes it was like trying to put a round peg in a square hole. But I found that the three case analysis works really well in the venture capital investment process and we use it at Union Square Ventures all the time.

What you do is this:

Get the management of the company you are considering an investment in (it could be an existing portfolio company if you are doing a follow-on round) to send you their financial model. Dig into it, understand how it is built, figure out where the drivers of revenues and costs are, and then figure out how to change them. The original model is the management case. You don’t need to make any changes to it for the first case.

Then step back from the model and think really hard about the challenges they are going to face in executing the business. Can they hire as fast as they want? Can they launch new products and services as fast as they want? Can they ramp sales as fast as they want? Then go back to the model and figure out what you really think the revenues will be. This is your Base Case. I generally recommend keeping the “fixed costs” the same as the management case. Don’t adjust headcount down. Only adjust down costs that are really completely variable with revenues.

Then step back again and think about what your nightmare scenario is. Maybe its that there will be no revenues at all for the time period you are modeling. Maybe it is that revenues will be flat. Or that they will grow very slowly. Whatever is the worst you can imagine, take the model there. THen adjust down headcount and costs across the board. But assume that it will take some time before management realizes that things aren’t working well and build that time delay into your reduced costs. This is your worst case.

For the venture capital investment process, you don’t need to do too much more. At this point, I suggest building a summary page where you lay out the profit and loss statement and cash balances for the time period you are modeling. Then do some valuation analyses on the P&L numbers to show what kind of value can be created in each of the three cases. You might even assign a probability to each case and get to a probability weighted valuation.

But probably the most important thing that you want to focus on is the cash balance (see my cash is king post). Take a look at how long the money you are investing will last in each of these three scenarios. And look at what the business is likely to be worth in each of the three scenarios when the money runs out. That will tell you if the suggested raise is enough money or not.

Most of what I have just written is aimed at people who are in the venture capital business, but I think its important for entrepreneurs to understand this methodology because its going to be used by investors who are considering an investment in your company. For entrepreneurs, I have some suggestions.

– build a good solid model that has at least a couple years of projections for revenues, cost, headcount, etc.
– make sure to create a cash flow projection that ties into the profit and loss. ideally you’d have a full balance sheet projection.
– make it easy to adjust the model so that it can be used for a scenario analysis
– do the worst case analysis before the venture capital investors do it so you’ll be prepared for the conversation

Charlie and I are working on one of these right now and the original model we got from the company was really well done. But the drivers were built using a drop down box with various percentage reductions in it. If you wanted to use a number bigger than what was in the drop down box, you were stymied. I guess that company couldn’t imagine a worst case as bad as we could! We asked them to open up the model for us and they were happy to do it. The point of this little story is that investors are always going to imagine a worst case that is worse than the entreprenuer is. That’s the nature of the Vc/entrepreneur relationship.

But focusing on the numbers before you write the check is always a good thing. And it often puts issues on the table for discussion that are ultimately beneficial for everyone.