1. Confidential – For Classroom Use Only Financial Projections

2. 2 Confidential - for classroom use only Strategy The business plan must describe the new venture’s strategy: 1.What to sell and to whom 2.What activities need to be performed to deliver goods and services to customers for sales and cash flow targets to be met 3.What resources need to be available and what infrastructure needs to be in place for these activities to be performed efficiently and for efficiency to improve over time

3. Confidential – For Classroom Use Only Critical Success Factors 1.First, identify the key value drivers of your company’s strategy. 2.Second, to the extent possible, determine the range of potential outcomes for those drivers. 3.Third, identify the potential early warning signs that would suggest these drivers are headed in one direction or another. 4.Finally, focus your data gathering and other intelligence efforts around these value drivers. These are the data that are most important for updating your strategy over time. 3 John F. Rockart, Chief executives define their own data needs (Harvard Business Review: Mar-Apr 1979).

4. 4 Types of Financial Statements 1.Income statement Revenue – Expenses = Income 2.Balance sheet Assets = Liabilities + Equity 3.Statement of cash flows Cash from operating activities Cash from investing activities Cash from financing activities

5. 5 Confidential - for classroom use only The Income Statement A financial statement that measures a company's financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period, typically over a fiscal quarter or year. It is also known as the "profit and loss statement" or "statement of revenue and expense". http://www.investopedia.com/terms/i/incomestatement.asp?viewed=1 Revenue 1,000 Cost of Goods Sold (COGS) 600 Gross Profit 400 Other Operating Expenses 250 Operating Income 150 Add: Non-Operating Revenue 15 Less: Non-Operating Expenses 10 EBIT 155 Interest Expense 40 EBT 115 Income Taxes - Net Income 115

6. 6 Confidential - for classroom use only Building Projections Utilize multiple worksheets 1.Assumptions worksheet 2.Calculations worksheet 3.Summary worksheet for large, complicated spreadsheets Focus on –fixed and variable costs –breakeven –sales forecasts –lag between sales and collection of cash –lag between acquisition of resources and payment for resources –free cash flow, not accounting income –compensation and return - how and when the money comes out to investors –clear assumptions BE CAREFUL OF SPREADSHEET MYOPIA

7. 7 Confidential - for classroom use only Common Mistakes in Building Projections 1.No understanding of –revenue drivers –cost drivers 2.Underestimating –time to revenue –time to secure financing –costs R&D regulatory approval production and order fulfillment marketing and sales

8. Confidential – For Classroom Use Only Identifying Revenue Drivers 8 Revenue is a function of 1.Number of units sold 2.Price per unit Number of units sold is a function of 1.Market size 2.Market share Price per unit is a function of 1.Total cost per unit 2.Competitor offerings 3.The value proposition 4.Market entry strategy Market size is a function of 1.The number of current customers 2.The number of potential customers 3.Quantity purchased by customer Market share is a function of 1.The value proposition 2.The business model 3.The rate and cost of customer acquisition 4.The pace and cost of ramping up operations 5.The marketing plan and market entry strategy

9. 9 Confidential - for classroom use only First Decision: Deciding What to Sell In a high tech firm, technology itself either is the product or gives rise to the product, which gives rise to the following questions: –Should the firm sell the knowledge itself or possibly license it? –Should the firm commercialize the idea – marketing, distributing, and selling a full solution including service and support –Or, given that final products can be “decomposed” into subsystems and components, should firms manufacture and sell some subsystem or component on an OEM basis Possible options: 1.Sell or license know-how only –Requires the greatest additional expenditures of funds by the customer after the transaction to realize the intended benefit 2.Sell proof-of-concept –Sale may include a prototype or pilot to establish that the know-how can be made to work 3.Sell commercial-grade components to OEMs –Firms may manufacture and sell components that are ready to use in another firm’s manufactured product 4.Sell final products or systems with all essential components, ready for use “out of the box” –For example, Dell computers 5.Sell a complete, end-to-end solution –This whole product solution delivers the intended benefits directly to customers with no need for them to incur additional expenditures on complementary items The decision is based on the amount of required expenditures by customers to drive the intended benefits above and beyond their acquisition costs, and to reduce their uncertainty Jakki Mohr, Marketing of High-Technology Products and Innovation, (Prentice Hall: 2001)

10. 10 Confidential - for classroom use only Estimating Revenues: Rate of Adoption The Bass Model or Bass Diffusion Model …consists of a simple differential equation that describes the process of how new products get adopted in a population. The model presents a rationale of how current adopters and potential adopters of a new product interact. The basic premise of the model is that adopters can be classified as innovators or as imitators and the speed and timing of adoption depends on their degree of innovativeness and the degree of imitation among adopters. …the three key parameters in the Bass model – usually called m, p, and q. 1.M is the total market size and provides the scale of the demand forecast, a total consumer base, or a terminal value of total adopters that will not be exceeded. 2.P and q determine the particular shape of of the adoption curve, i.e. how fast or slow the adoption of a new product is expected to proceed. 3.The coefficient p is called the coefficient of innovation, external influence or advertising effect. 4.The coefficient q is called the coefficient of imitation, internal influence or word-of-mouth effect. http://en.wikipedia.org/wiki/Bass_diffusion_model Elie Ofek, Forecasting the Adoption of a New Product (Harvard Business School Publishing: 2009)

11. 11 Confidential - for classroom use only http://en.wikipedia.org/wiki/Bass_diffusion_model The coefficient p is called the coefficient of innovation, external influence or advertising effect. The coefficient q is called the coefficient of imitation, internal influence or word-of-mouth effect. Typical values of p and q when time t is measured in years: –The average value of p has been found to be 0.03, and is often less than 0.01 –The average value of q has been found to be 0.38, with a typical range between 0.3 and 0.5 Bass found that his model fit the data for almost all product introductions, despite a wide range of managerial decision variables, e.g. pricing and advertising. This means that decision variables can shift the Bass curve in time, but that the shape of the curve is always similar. The Bass Model

12. 12 Confidential - for classroom use only Estimating Revenues: Pricing Pricing begins with a deceptively simple question: what is the appropriate baseline price for an offering? The price of a product or service can play a critical role in encouraging or discouraging adoption, particularly in a third-party payer environment. Therefore, pricing not only involves establishing a baseline price for the customer, but recognizing the different ways through which prices (and the related issue of reimbursement) will influence adoption. Before innovators think about setting a baseline price, they must first understand all of the costs associated with developing, manufacturing, and marketing the offering. They should also determine what sort of mark-up (profit) the company would ideally earn to support its overhead and ongoing development efforts. Value-based pricing is typically the easiest type of pricing strategy for a company to support. If the price of a new technology can be directly linked to the value it will deliver (with the value exceeding the cost), buyers and payers are far more likely to support the adoption of the offering. The most persuasive value-based pricing argument is related to direct savings in healthcare costs. Another way that companies can establish a baseline price is to perform a comparables analysis. By evaluating the pricing strategies (and associated reimbursement status) of similar offerings in the field, companies can gain valuable information to help them choose a price. In general, medical device pricing for established products should give the innovator a strong sense of what the market will bear. Differential pricing refers to the basic concept of pricing the same product or service differently for different customer segments. Bundled pricing refers to setting a single price for a combination of products and/or services. A medical device manufacturer might bundle service contracts or ancillary products and services with its primary offering to try to drive increased revenue. Bundled pricing can be a way of offering discounts to buyers while incentivizing them to buy a wider range of products and services than they would otherwise. Stefanos Zenios, et. al., Biodesign (Cambridge University Press: 2010)

13. 13 Confidential - for classroom use only Cost Allocations for Value Based Pricing

14. Confidential – For Classroom Use Only Identifying Cost Drivers 14 Cost is a function of 1.Units sold 2.Cost per unit 3.Overhead 4.Financing 5.Seasonality Units sold is a function of 1.Market size 2.Market share Cost per unit is a function of 1.Variable Costs: expenses that change in proportion to the activity of a business; in other words, variable cost is the sum of marginal costs 2.Fixed Costs: business expenses that are not dependent on the level of production or sales; they tend to be time- related, such as salaries or rents being paid per year or month 3.Discretionary Costs: fixed costs changed easily by management decision such as advertising, repairs and maintenance, and research and development; also called managed costs 4.Step Costs: costs that are approximately fixed over a small volume range, but are variable over a large volume range 5.Committed Costs: sunk costs, i.e. past outlays or losses that cannot be altered by current or future actions Overhead is a function of 1.Fixed Costs 2.Discretionary Costs 3.Step Costs 4.Committed Costs 5.The cost of ramping up operations Financing is a function of 1.The scale of investment in fixed assets and working capital 2.The degree and terms of equity financing 3.The degree and terms of debt financing Seasonality is a function of 1.The sales cycle 2.Demand elasticity

15. 15 Confidential - for classroom use only Estimating Costs You will need to estimate the 1.Cost to invent 2.Cost to produce 3.Cost to deliver 4.Cost to support 5.Cost to market and sell 6.Cost to manage the enterprise

16. 16 Confidential - for classroom use only Examples of Cost Elements People –Managers –Researchers –Clerical and support –Operations and production –Marketing and sales Administrative –Rent for facilities –Telephone and utilities –Office supplies –Insurance –Accounting and legal –Patenting –Consulting Sales and Marketing –Travel –Conventions –Brochures –Advertising Operations and Research –Clinical trials –Prototypes and samples –Lab supplies –Production supplies –External testing –Equipment repairs and maintenance –Depreciation Distribution –Order fulfillment –Billing –Shipping –Packaging –Rebates Initial Investment –Fixed assets (e.g. production equipment, research equipment, office computers and equipment, distribution vehicles) –Working capital

17. 17 Confidential - for classroom use only Sample Template Notes: 1.No negative ending cash 2.Ending cash should be sufficiently large to ensure a margin of safety 3.Investment is the plug - whatever is needed to avoid negative ending cash 4.No taxes - assume LLC as the Legal form of the business 5.No distributions of cash - investors can draw their own conclusions 6.Calculations should tie back to assumptions worksheet

18. 18 Confidential - for classroom use only Financial Projections and Timelines You will need to estimate: 1.Key milestones, e.g. a.Research and development goals b.The time to FDA approval c.Hiring of key employees 2.Financing requirements Financial projections need to reflect the successful completion of key milestones

19. 19 Confidential - for classroom use only Another Template: Contribution Margin Statements Contribution margin can be thought of as the fraction of sales that contributes to offsetting fixed costs. Calculated as revenue less variable costs. Contribution Margin Statement:

20. 20 Confidential - for classroom use only Example: Operating Risk

21. 21 Confidential - for classroom use only Example: Contribution Margin Statement Saw Mill Pallet Mill Mulch Fire Logs Total Units Sold 45,000 1,580,000 26,000 34,000 Revenue 2,600,000 3,800,000 240,000 310,000 6,950,000 Variable Costs 1,900,000 1,300,000 40,000 90,000 3,330,000 Contribution Margin 700,000 2,500,000 200,000 220,000 3,620,000 Contribution Margin %26.92%65.79%83.33%70.97%52.09% Fixed Costs 3,410,000 Operating Profit 210,000 Operating Profit %3.02%

22. 22 Confidential - for classroom use only Breakeven Analysis Breakeven Units = Fixed Costs + Target Profit Contribution Margin per Unit Breakeven Dollars = breakeven units x price per unit Financial risk: –the additional risk a shareholder bears when a company uses debt in addition to equity financing –companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity Operating risk: –risk arising from execution of a company's business functions. As such, it is a very broad concept including e.g. fraud risks, legal risks, physical or environmental risks, etc. –the inherent or fundamental risk of a firm, without regard to financial risk; the risk that is created by operating leverage; also called business risk http://www.investopedia.com/terms/f/financialrisk.asp http://en.wikipedia.org/wiki/Operational_risk http://financial-dictionary.thefreedictionary.com/Operating+risk

23. 23 Confidential - for classroom use only Relevance What financial information is meaningful for the preparation of financial projections? 1.Projected financial statements Income statement, contribution margin statement 2.Cash flow Showing sources and uses of cash, beginning cash, and ending cash 3.Differential revenues and costs Focus only on those elements that will be different among alternatives 4.Incremental analysis Focus only on those elements that will be incremental to a current situation 5.Sunk costs Generally irrelevant for projections

24. Additional Funds Needed (AFN) Additional Funds Needed (AFN) is a financial concept used when a business looks to expand its operations. Since a business that seeks to increase its sales level will require more assets to meet that goal, some provision must be made to accommodate the change in assets. To phrase it another way, the business must have some plan to actually finance the new assets that will be needed to increase sales. – AFN is a way of calculating how much new funding will be required, so that the firm can realistically look at whether or not they will be able to generate the additional funding and therefore be able to achieve the higher sales level. Determining the amount of external funding needed is a key part of calculating AFN. A simplified version of the AFN equation is as follows: AFN = Projected increase in assets - Spontaneous increase in liabilities - Any Increase in Retained Earnings When calculating AFN, consideration must be given to whether the company is already operating at full-capacity; if not, they can expand sales some without having to invest in new equipment. – If a negative value is found for AFN, that means that the action would generate extra income that could be invested elsewhere. 24 Confidential: For Classroom Use Only http://en.wikipedia.org/wiki/Additional_Funds_Needed

25. Example: Income Statement Tasha’s Toy Emporium Income Statement, 2006 % of Sales Sales5,000 Less: costs(3,000)60% EBT2,00040% Less: taxes (40% of EBT) (800)16% Net Income1,20024% Dividends600 Add. To RE600 Tasha’s Toy Emporium Pro Forma Income Statement, 2007 Sales5,500 Less: costs(3,300) EBT2,200 Less: taxes(880) Net Income1,320 Dividends660 Add. To RE660 25 Assume Sales grow at 10% Dividend Payout Rate = 50% Confidential: For Classroom Use Only

26. Example: Balance Sheet Tasha’s Toy Emporium – Balance Sheet Current% of Sales Pro Forma Current% of Sales Pro Forma ASSETSLiabilities & Owners’ Equity Current AssetsCurrent Liabilities Cash$50010%$550A/P$90018%$990 A/R2,000402,200N/P2,500n/a2,500 Inventory3,000603,300 Total3,400n/a3,490 Total5,5001106,050LT Debt2,000n/a2,000 Fixed AssetsOwners’ Equity Net PP&E4,000804,400 CS & APIC2,000n/a2,000 Total Assets9,50019010,450 RE2,100n/a2,760 Total4,100n/a4,760 Total L & OE9,50010,250 26 Confidential: For Classroom Use Only

27. Example: Additional Funds Needed The firm needs to come up with an additional $200 in debt or equity to make the balance sheet balance – TA – TL&OE = 10,450 – 10,250 = 200 Choose plug variable ($200 external fin.) – Borrow more short-term (Notes Payable) – Borrow more long-term (LT Debt) – Sell more common stock (CS & APIC) – Decrease dividend payout, which increases the Additions To Retained Earnings 27 Confidential: For Classroom Use Only

28. Growth and External Financing At low growth levels, internal financing (retained earnings) may exceed the required investment in assets As the growth rate increases, the internal financing will not be enough and the firm will have to go to the capital markets for money Examining the relationship between growth and external financing required is a useful tool in long-range planning 28 Confidential: For Classroom Use Only

29. The Internal Growth Rate The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. Using the information from Tasha’s Toy Emporium ROA = 1200 / 9500 =.1263 b =.5 (where b = retention ratio, i.e. the amount not paid out as dividends) 29 Confidential: For Classroom Use Only Conclusion: This firm could grow revenue and assets at 6.74% per year without raising additional external capital.

30. The Sustainable Growth Rate The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt (but not equity) to maintain a constant debt ratio. Using Tasha’s Toy Emporium ROE = 1200 / 4100 =.2927 b =.5 30 Confidential: For Classroom Use Only Conclusion: This firm could grow revenue and assets at 17.14% per year without selling additional equity.

31. Determinants of Growth ROE = Profit margin X Total asset turnover X Equity multiplier ROE = (Net Income / Sales) X (Sales / Total Assets) X (Total Assets / Total Equity) Anything that increases ROE will increase the sustainable growth rate by making the top bigger and the bottom smaller. Increasing the plowback ratio will have the same effect. A firm’s ability to sustain growth depends explicitly on the following four factors: 1.Profit margin – operating efficiency: An increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth. 2.Total asset turnover – asset use efficiency: An increase in the firm’s total asset turnover increases the sales generated for each dollar in assets. This decreases the firm’s need for new assets as ales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as decreasing capital intensity. 3.Financial leverage – choice of optimal debt ratio: An increase in the debt-equity ratio increases the firm’s financial leverage. Because this makes additional debt financing available, it increases the sustainable growth rate. 4.Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm: A decrease in the percentage of net income paid out as dividends will increase the retention ratio. This increases internally generated equity and thus creases sustainable growth. 31 Confidential: For Classroom Use Only

32. 32 Confidential - for classroom use only Some Advice Financial projections are less a matter of mathematical aptitude and more a matter of your knowledge of your business, the industry, and the market. To make projections, such as sales forecasts, break down sales into manageable parts. For example, first outline the products and services you offer, the unit price for each item, the anticipated inventory, projected sales per item for each day, week, month, etc. You will base these numbers on your experience in the industry and research. Finally, make an educated guess regarding total sales. Using the same procedure, calculate your expenses or startup costs if launching a new business. Use a template or sample as a guide. Estimates, such as sales, are not simply based on knowing the number of people in your demographic region and making an educated guess as to how many will opt to use your product or services in a given time frame. Sales are projected in line with your marketing strategy. For example, if part of your plan is to do a bi-monthly direct mailing to 10,000 people in your demographic group, and you estimate that a 1 percent response to that mailing will result in sales at your store, then you are estimating that 100 people will make a purchase in two months, or 50 per month. If the average sales item in your store is $200, you are looking at an estimated $10,000 per month using this means of marketing. Of course, you may choose to take a conservative approach and estimate $7,500. Break down each method of marketing used to attract customers. In the end, review the plan to make sure everything is included. Finally: –Ask other people in the industry, whom you trust, to review the plan. –Match your financial forecasts against that of sample plans. –Recheck all numbers and calculations. –Look for any risks that could impinge upon your plan. http://www.allbusiness.com/business-planning-structures/business-plans/1729-1.html

33. 33 Confidential - for classroom use only Some More Advice Creating financial projections for your startup is both an art and a science. Although investors want to see cold, hard numbers, it is tough to predict your financial performance three years down the road, especially if you are still raising seed money. Regardless, a short- and medium-term financial projection is a required part of your business plan if you want serious investors’ attention. Here are some tips for crafting solid financial projections. 1.Get Comfortable with Spreadsheets 2.Go Beyond the Income Statement 3.Provide Short-Term and Medium-Term Projections 4.Account for Startup Fees 5.Offer Two Scenarios ONLY 6.Make Your Assumptions Reasonable and Clear As mentioned before, financial forecasting is as much art as it is science: You’ll have to assume certain things, such as your revenue growth, how your raw material and administrative costs will grow, and how effective you’ll be at collecting on accounts receivable. It’s best to be realistic in your projections as you try to recruit investors. If your industry is going through a contraction period and you’re projecting revenue growth of 20 percent a month, red flags will begin to pop up. http://entrepreneurs.about.com/od/businessplan/a/financialproj.htm

34. 34 Confidential - for classroom use only Summary Financial projections are less a matter of mathematical aptitude and more a matter of your knowledge of your business, the industry, and the market. 1.Sales should be projected in line with your marketing strategy 2.Break down sales forecasts into manageable parts 3.Cost projections should directly follow from sales forecasts and should be organized into appropriate categories 4.Incorporate milestones 5.Consider ramp-up and seasonality 6.Incorporate risk into the projections 7.Focus on cash flow and critical success factors 8.Focus on funding requirements and sources

35. 35 Confidential - for classroom use only Preparing Financial Projections for Medtech (From the Stanford Casebook)

36. 36 Confidential - for classroom use only Financial Model Fundamentals As part of the business plan, the operating plan and financial model should assist entrepreneurs in conceptually integrating the many activities underway within the biodesign innovation process. The operating plan provides an overview of the milestones and time needed to develop an innovation. It also provides inputs that are key to the financial model. The financial model allows entrepreneurs to model various scenarios and understand their impact on the business—most importantly, what events would better demonstrate the validity of the new venture and how these events can be used to develop the business and secure necessary funds. Ultimately, taken together, the financial model and operating plan enable entrepreneurs (and potential investors) to determine how much will it cost to build the business, how much funding must be raised along the way, and what timeframes should be associated with each funding round to minimize dilution and maximize the probability of success. Once a best-case scenario has been developed and a financial model has been finalized, a cash flow statement and income statement can be produced to provide a complete financial picture for the business. The financial model lays out the revenue, cost, and profit projections for the business and provides an estimate of the funds needed to reach key milestones. To develop this financial information, entrepreneurs draw on decisions made through the process of developing strategies to address intellectual property (IP), regulatory, clinical development, reimbursement, research and development (R&D), stakeholder, marketing, sales and distribution. A sound financial model usually has six key components: 1.Operating plan 2.Staffing plan 3.Market model 4.Cost projections 5.Income statement 6.Cash flow statement

37. 37 Confidential - for classroom use only Operating and Staffing Plans Operating Plan The operating plan provides an overview of how long it will take to develop the innovation and the key milestones a company will achieve along the way. Typically, the operating plan takes a five-to-seven-year view of the business, broken down by quarter. High-level milestones that should be included in the plan correspond to these common phases of a company’s evolution: 1.Proof of concept 2.Product development progress 3.Manufacturing feasibility 4.Clinical trials and FDA submission 5.Reimbursement initiatives 6.Development of scalable manufacturing 7.Marketing and sales (U.S., Europe, Asia) Staffing Plan The staffing plan outlines the number of employees that need to be hired over time. These hiring needs are often broken down by quarter (and sometimes by month). The staffing plan is a direct outgrowth of the steps in the operating plan, since staffing requirements should be determined by the company’s strategic and operating decisions. Essentially, an entrepreneur needs to figure out the type of employees (in terms of skill sets or function) and overall number of employees required to achieve the milestones set forth in the operating plan. In general, staffing numbers should be based on the strategy that the company plans to pursue, and will vary based on factors such as the regulatory pathway, reimbursement environment, and sales model that has been chosen. For example, a direct sales force can require as many as 100 200 sales representatives (reps) at a peak, while a two to three person sales team might be sufficient to support an indirect sales model. As well, the size of the target physician population (e.g. a smaller specialty as compared to the large numbers of primary care doctors) can affect the sales force required significantly. Reimbursement may require a team of up to 10 people if an intense reimbursement effort is anticipated and a high level of support is desired. On the other hand, one or two consultants may be sufficient if codes and favorable coverage decisions are already in place. One way to roughly check if the number of employees reflected in the staffing plan is reasonable is to use commonly accepted staffing ratios and formulas. For example: –Selling, General, and Administrative Expenses (SG&A) to R&D – Typically, the ratio of SG&A employees to R&D employees equals roughly three in a mature medical device company. (It is important to note that this ratio may be very different in the early phases of a business as a product is being developed.) –Product units per assembler – If the company intends to assemble or build the product in-house, it must be sure to have enough assemblers to meet demand for the product. Calculate the total number of units produced by each assembler to make sure it is a reasonable match to anticipated demand and reasonable for an assembler to achieve in a given time period. If either of these are not the case, more or fewer assemblers may be needed. The product units per assembler ratio indirectly relies upon the market model, which defines the number of units that need to be produced for a given time period. Stanford casebook.

38. 38 Confidential - for classroom use only Market Model There are two ways to approach market models: top-down or bottom-up. Fundamentally, the top- down model provides a high level estimate of the market based on broad, embedded assumptions about a company’s ability to access the market. In most cases, a top-down model is built based on the availability of strong comparable data from other companies in similar market spaces. A bottom-up model, on the other hand, is developed “from scratch” to provide the entrepreneur with a granular understanding of the business and the market in which it operates. While top-down models can be useful in developing “back of the envelope” market estimates, entrepreneurs are encouraged to develop a market model from the bottom-up for inclusion in the financial model. This approach helps to ensure that the cascade of assumptions relied upon to develop the numbers are fundamentally sound and well understood. It lends credibility to the model and provides the entrepreneur with confidence when asked to defend it. And, it helps familiarize the entrepreneur first-hand with how changes, big and small, may affect the company’s ability to get to market so that s/he can anticipate the impact and appropriately mitigate risks. Stanford casebook.

39. 39 Confidential - for classroom use only Top-Down Model A top-down market model forecasts projected yearly revenue by outlining the segments of the market that will be addressed and by determining how many customers the company intends to service (the number of patients that will be treated, hospitals/offices that will be sold to, etc.). Then multiplying the number of customers by the price of the innovation. This approach is useful for quickly confirming how attractive the market is to pursue. As noted, a top-down market model is based entirely on a number of statistical assumptions. Entrepreneurs can find many of these key statistics in scientific journals. Remember to cite all references to support the projections as this lends increased credibility. When determining market share, bear in mind that market share growth depends on a number of factors: 1.How innovative/unique is the technology? 2.How likely are physicians to adopt the new technology? 3.How aggressive is the sales plan? 4.How many competitors already exist and what resources do they have? 5.How many sales reps will be hired? In general, no company should expect to win more than 30 percent market share (relative to other competitors) in any segment of the medical device industry. Experts encourage entrepreneurs to plan on no more than 0.1 percent market share in the first year, ramping up to a maximum of 15 percent.

40. 40 Confidential - for classroom use only Bottom-Up Model 1.Determine the fundamental business unit – In this first step, the key is to determine What drives business in the market. For a company selling capital equipment, the unit of business is the number of facilities that purchase the machine; the number of patients treated or number of physicians using the equipment is not the core driver of sales. For most medtech companies, however, physicians are often the key unit of business because they are the ones that drive the selection, sale, and use of a device. Unless a company is dealing with an over-the-counter or fee-per-use business model, patients rarely serve as the fundamental business unit in the device arena. The most common business units are facilities and physicians. 2.Consider the sales cycle – The sales cycle involves all of the time and expense required to sell one unit of business. This includes the time and cost of raising the buyer’s awareness of the technology, getting him/her interested, and closing the deal. If the buyer is a facility or hospital, standard purchasing processes and cycles (which can often be lengthy) must be taken into account. If the buyer is a physician, the time and cost of training him/her to use the device must also be calculated, as well as any follow up training. For new sales reps, a learning curve must also be factored in to these calculations (the amount of time and the cost of training the rep before s/he makes a first sale). 3.Consider the adoption curve – The adoption curve refers to the rate at which the buyer will utilize or consume the technology. For devices that present a relatively low risk and/or obvious benefits, the number of devices used over a given unit of time may grow relatively steadily. However, for higher risk device or technologies perceived as being more experimental, utilization may grow more gradually. For instance, a physician may perform a first procedure using the technology and then wait for several months to see how that preliminary patient responds before performing another. Certain facilities and medical specialties may have a tendency to adopt new technologies faster than others, which should also be taken into account when developing the adoption curve. The key is to derive the anticipated utilization rate for a single unit of business on day one, day two, etc. to get a sense for how quickly the company will be able to build its sales volume. A typical metric that can be used to capture utilization is the percentage of the case volume of the business unit that utilizes the venture’s products.

41. 41 Confidential - for classroom use only Bottom-Up Model (contd.) 4.Build the commercial effort – At this point, the entrepreneur stops thinking about what required to make individual sales to a single unit of business and starts thinking about how many sales reps to hire to build a reasonable business. From step 1, the entrepreneur can determine how many units of business exist within the target market. From step 2, s/he understands how much total effort is required and expected to make each sale. From step 3, s/he has estimated a realistic adoption rate. Now, the challenge is to pull these factors together to determine how many sales reps are needed to grow the business at an appropriate, realistic pace. The key is to balance the entrepreneur’s desire for “reward with his/her tolerance for risk. Hiring too many sales reps at once can be a costly mistake until key assumptions regarding the sales cycle and adoption curve have been tested in the market. On the other hand, the company needs to be able to drive enough sales within a realistic time frame to sustain its operations and keep its commitments to investors. Typically, it is advisable to run multiple scenarios (what would it look like to Start with 5 sales reps? 10 sales reps? 15 sales reps?), then choose the one that strikes the best risk/reward ratio. 5.Consider market development factors – The next step is to consider other factors in external environment that have the ability to affect the overall market model. For example, reimbursement coverage can have a major effect on market adoption. If reimbursement has not yet been achieved, this could affect the size of the initial sales force that is appropriate. Similarly, if professional societies have not yet endorsed the technology or key data have not been published, it may be wise to start with a smaller sales force focused on converting early adopters until some of these other factors have been out into place to support more widespread sales. Importantly, the top-down market model does not explicitly take these types of factors into account, which is one of its inherent weaknesses. 6.Factor in product evolution – If the entrepreneur anticipates that subsequent versions of the technology will become available within a one to three year timeframe, this should be reflected in the market model. New versions of a technology have the potential to increase utilization based on the improvements made and/or features added that potentially make the technology relevant to a greater number of procedures. 7.Consider other factors – Finally, an entrepreneur should look closely at the market, the buyer, and the technology to determine if there are any other factors that might affect sales. For example, some medical specialties are more seasonal than others (e.g.. Orthopedics is busiest in the winter and the summer when people participate in seasonal sporting activities). Buying behavior in certain medical specialties can also be influenced by major medical conferences that occur at a certain time of year (when physicians and hospital administrators convene to check out new technology in the field). These types of considerations should be factored into the overall market model and the timing of key market decisions.

42. 42 Confidential - for classroom use only Cost Projections Cost projections (also called the operating statement) calculate the estimated costs of the business, including cost of goods sold (COGS) and operating expenses (OpEx). COGS refers to how much it costs for the company to make the products it sells. While the elements of this calculation vary, they typically include raw materials, labor, and facilities costs related to making the product. OpEx captures all other costs not included in COGS, including R&D, sales staff, general and administrative functions, and non-production facilities costs. A cost analysis can be performed at varying levels of detail. It is up to the entrepreneur to decide how much detail is required to satisfy the target audience for the business plan. Salary Analysis The creation of cost projections begins with an employee salary analysis, which includes three main components: 1.Summarize the staffing plan by calculating the average number of hires per ;ear by type. 2.Outline annual salary assumptions, or how much the company will have to pay n salary employee type, for each position type (more information is provided below). 3.Calculate fully burdened annual employee cost by position, taking into account employee healthcare and other benefits, insurance, computers, desk chairs, equipment, etc. for each employee. The fully burdened cost represents the total annual cost for each employee. Benchmarks for average annual salaries are widely available. The following guidelines have been developed based on estimates from Salary.com and verified with an experienced entrepreneur in the medical device field: Rather than figuring out the exact fully burdened cost, many experts use a “back of the envelope” factor of two-times the annual salary of each employee (e.g., the fully burdened cost of a scientist would be $125,000 x 2 = $250,000). The 2x multiplier applies to all employees except manufacturing employees for which a 1.5x multiplier should be used. Additionally, do not forget to take into account annual salary increases, as well as the need to offer stock to attract and retain high caliber talent. The following guidelines indicate the amount of stock (or share of the company) that is typically required to recruit senior executives:  CEO – 5 to 8 percent.  Vice Presidents – 1 to 2 percent. Equity is generally granted to employees early in the start-up phase of the company (before or after the first round of funding) to help attract talent.

43. 43 Confidential - for classroom use only Cost of Goods Sold To calculate COGS, it is important to examine at least three key cost components: manufacturing labor costs, manufacturing facilities costs, and raw materials costs. To calculate manufacturing labor costs: 1.Multiply the number of engineers per year (from the staffing model) by their fully burdened salary cost to produce total engineer cost. 2.Multiply the total number of direct labor employees (e.g. assemblers, processors, testers) | per year by their fully burdened salary cost to produce total manufacturing labor cost. 3.Sum these figures to produce the total manufacturing labor cost. To calculate manufacturing facilities costs: 1.Estimate the cost of facilities space. In mid-2006, class A (top tier) office space in Silicon Valley averaged $2.21 per square foot per month (or approximately $27 per year) and class B (second tier) office space averaged $1.82 per square foot per month (or approximately $22 per year).” The assumption of $25 per square foot per year, inflated at 2.5 percent per year, was chosen for this model for both manufacturing and office Note that Silicon Valley rates can be considered to be at the higher end of the range. 2.Calculate space per employee by assuming 250 square feet per employee. This estimate an be reduced over time to 210 square feet per employee as manufacturing processes become more efficient. 3.Determine the total space required by multiplying the space per employee by the number manufacturing employees. 4.Make assumptions about projected facilities space. Try limiting the number of times employees are moved across facilities so that the company can buy facilities space in blocks and always has more facilities space than needed. 5.Finally, multiply the projected facilities space by the cost of facilities space to produce the manufacturing facilities cost. Calculate raw material costs: Multiply the total units forecast to be sold (taken from the market model) by the cost of raw materials per product. Finally, summarize these three cost elements and take their sum as the total COGS. It should be emphasized here that the process of developing a COGS model is tightly coupled with the company’s manufacturing strategy. Answers to the following questions must be available before accurate COGS model can be developed: What will the manufacturing process be? Will manufacturing be done in-house or will it be outsourced? What components can be made in-house and what components can be purchased or outsourced? Who will be the suppliers of the outsourced components and who will supply the raw material(s)? What kind(s) of equipment will be needed? What are the cost projections for these components?

44. 44 Confidential - for classroom use only Operating Expenses 1.Estimate R&D staff spending by multiplying the number of R&D-related employees per year by their fully burdened salary for each type of employee for a given year. In this example, engineers and technicians are considered R&D employees. All employee data is taken from the staffing plan and salary analysis. 2.Estimate clinical trials costs as follows: a.First, review the operating plan to determine the length of the clinical trials. The trial length and strategy should be determined early, as part of the overall operating strategy. b.Make an assumption about the number of clinical patients required, in this case 100 patients. c.Since year 2 includes 0.5 years of clinical trials, it includes 50 patient-years. Similarly, year 3 includes 100 patient-years. d.Make another assumption about the cost per patient-year, $15,000, which is a reasonable (but somewhat optimistic) estimate for invasive medical device clinical trials. (Cost per patient year is the cost of one patient participating in a clinical trial with one-year follow-up). e.Multiply the patient-years by the cost per patient-year and sum over the years involved, in this case years 2 and 3, to yield the total clinical trials cost. 3.Calculate SG&A staff spending in the same way as R&D staff spending. SG&A employees include sales reps, marketing and business development, clinical and regulatory employees, administrative assistants, and managers. 4.Determine non-manufacturing or SG&A facilities costs: a.Multiply the initial cost per square foot (usually higher than the cost of a manufacturing facility since usually represents office space) by inflation (2.5 percent) to determine the actual cost per square foot in each year. b.Multiply the number of square feet per employee by the number of employees per year to produce the square footage required per year. c.Choose facilities sizes in each year that can handle the space requirements while keeping the number of moves to a minimum; this will require moving into a larger space than needed at the time of a move, but will allow for growth before the need to move again arises. d.Multiply the actual cost per square foot per year by the facilities size per year to produce actual facilities costs per year. e.Then, take the R&D, SG&A, and facilities expenses and sum them to calculate the company’s total OpEx. It is worth noting that clinical and regulatory staff is sometimes categorized under R&D staff and sometimes under SG&A. Regarding clinical trials, costs can vary widely depending on the invasiveness of the device and length of follow-up. It is not unreasonable to expect that the cost may range from as little as,000 per patient-year (or $14,000 per patient on average) for a non-implantable device with a short follow-up time, to as much as $15,000 to $20,000 per patient-year (or $25,000 to $35,000 per patient on average) for an implantable or therapeutic device which typically requires a lengthy follow-up period. The cost of a trial may also depend on whether some of the expenses for treating the patient (e.g. physician and facility reimbursement) will be covered by Medicare and private payers. Additionally, the number of patients in the trial should be based on the number of patients statistically needed to establish a particular clinical result.

45. 45 Confidential - for classroom use only Income Statement The income statement brings together all of the elements of the financial model calculated above into a unified view of the company’s expected financials. It is also known as an earnings statement, statement of operations, or profit and loss (P&L) statement. It includes the following line items: 1.Revenue: Total sales for the year 2.COGS: Includes cost of raw materials and labor to assemble the device and any other component that went directly into the production of the device. Does not include expenses such as marketing, sales rep costs, management salaries, etc. 3.Gross margin: Revenue minus COGS 4.OpEx: All the other expenses associated with running the business that were not incorporated into COGS. Includes items such as R&D, facilities, rentals, SG&A, company functions, etc. 5.Operating income: Operating margin – operating expenses When investors examine an income statement, they typically apply a series of guidelines to check and see if the financial plan is realistic. The following are principles that apply to mature medical device companies: 1.A typical gross margin at maturity should be around 70 percent (gross margin equals revenue less COGS). Many companies target a 60 percent gross margin in their initial business plans. 2.R&D is roughly 10-15 percent of sales at maturity. 3.SG&A expenses are roughly 30 percent of sales. 4.While not usually highlighted as a separate line on the income statement, SG&A facilities expenses are roughly 1 percent of sales.

46. 46 Confidential - for classroom use only Cash Flow Statement At this point, the entrepreneur is ready to determine the exact cash needs of the business, which is not the same as the net result of the income statement. The discrepancy is due to a concept called depreciation. Sometimes when a business spends cash, it does not record it as a cost on the income statement right away. For example, the company may purchase a computer for $1,000 which has a useful life of three years. On the income statement, the company may record a cost of $333 per year, representing the expended value of the computer each year. However, it still requires $1,000 cash up-front to make the purchase. Similarly, the company will need to Spend cash on raw materials to build its product, but it will take time before the products are sold (and therefore recognized as sales on the income statement). As a result, cash will move out of the hands of the company before the company recognizes the corresponding revenue. When a company’s cash is equal to zero, the business is essentially bankrupt. For this reason, having a cash requirements plan is extremely important. Such a plan can also help the company balance the need to be frugal with the need to allow appropriate spending to support the growth of the business—a. delicate but essential balance that every company must strike. Completing a cash requirements plan requires the following steps: 1.Begin with an actual pre-tax operating profit (less) from an income statement. Add in elements representing cash flow “out the door” that are not immediately deducted from the income statement. These can include: –Capital equipment purchased Cost of capital equipment per employee. This includes cost of computers, phones, desks, etc. Cost of clean rooms in the years that manufacturing facilities are developed. Cost of manufacturing equipment. –Raw materials costs (taken from COGS analysis when developing cost projections) needed to build up inventory 2.Subtract these elements from the pre-tax operating profit (loss) to produce total cash flow year. 3.Next, add cumulative cash flow from the prior year (presumably $0 prior to first year) to total cash flow from the current year to produce cumulative cash flow for the current year. Prior to any financing, the cash balance listed under cash needs will be the same as cumulative cash flow. 4.By looking at the cash requirements based on cumulative cash flow (i.e., how much is the minimum required for cumulative cash flow to be positive), input in various amounts representing the financing to be raised. The choice of how much money to raise and at what milestones or time points to raise it are key strategic decisions. Implicit in this is also how long each financing round will allow a company to have positive cash flow. 5.After determining the desired financing, calculate the post-financing cash in the bank by adding the (pre-financing) cash balance to the current year financing. 6.Adjust all subsequent year (pre-financing) cash balances by adding the prior year’s cash the bank to the current year’s cumulative cash flow. 7.Repeat steps 4-6 for each subsequent round of financing moving forward in order to maintain positive cash flow. This will be required until a company has sufficient pre-tax operating profits (based upon revenue) which can independently keep cash flow positive.

47. 47 Confidential - for classroom use only Profitability In developing a financial model, it is important to determine a realistic profit goal. This profit goal will directly affect the company valuation since the valuation is a function of earnings (this relationship is known as the price/earnings (P/E) ratio). Other considerations that will also impact the business’ valuation include: 1.Revenue Ramp – How quickly the company expects to grow its revenue. 2.Time to Profitability – How long it will take the company to break even, and then turn a consistent operating profit. 3.Operating Profit Percent – What operating profit the company expects to achieve as a percentage of revenue. 4.Competitive Benchmarks – Benchmarks and comparable data related to the type of business model the company has chosen (e.g., disposable, reusable, capital equipment; and the sector/industry within which the company operates (e.g., devices, genomics, pharmaceuticals). Typically, a reasonable operating profit goal should be 30 percent of pre-tax income in the long term. However, how the company achieves this goal will depend upon its go-to-market strategy. A company might choose a direct sales strategy, in which case it would not have to share revenue with distributors, resulting in high gross margins; but it would have to hire a large sales force, resulting in high sales costs. Alternatively, the company could choose to use distribution partners, resulting in lower gross margins but lower sales costs. Another option is to blend the two Strategies, employing distributors in some markets and direct sales in others. Below are sample figures for these three strategies, all achieving the same objective of a 30 percent pre-tax profit margin. Once the expenses of the company and timing of milestones have been laid out, it is then possible for the entrepreneur to assess when to finance the company and at what levels. However, in some cases, it becomes clear that not enough important milestones occur within a certain timeframe to align investor interest with the funding needs of the business. As a result, it may be necessary to either raise more money upfront to cover the company through these periods, or reconsider the operating plan to allow for a more continuous flow of value-building milestones. Once this effort has been completed, it will be possible to define the discrete timeframes that occur immediately after key value-building milestone events where the business can be compared to comparable proxy companies (i.e., those whose operations resemble is required to commercialize an entrepreneur's innovation, the idea being that historical precedents can be used as a basis of comparison for how to commercialize an idea). and a valuation range can be established. It will be this valuation, plus the cash raised by the business, that will determine the dilution of existing shareholders and ownership of investors at each stage. Stanford casebook. Strategy 1 (direct sales)Strategy 2 (mixed)Strategy 3 (using distributors) Gross Margin70 percent60 percent50 percent Marketing, Sales, and Administration 30 percent20 percent10 percent R&D10 percent Profit Pre-Tax30 percent