Financing Bioeconomy Ventures: Part 2 – The Pro Forma

Gerald Kutney

By Gerald Kutney, Lee Enterprises Consulting
Special to The Digest

This is Part 2 of an 11-part series. Part 1 is here.

Developing a pro forma projection for an investment opportunity is the first step for an entrepreneur seeking capital, and also the first screening level financing institutions use to evaluate such proposals. There are three fundamental areas of concern when preparing a pro forma analysis: focusing on critical near-term events, making the most accurate input assumptions and choosing an effective pro forma analysis platform.

Is ROI always King?

When you first talk with an early-stage technology biofuel or renewable chemical entrepreneur or project promoter, the first thing you usually hear about their project is that it has a good return on investment (ROI). The ROI has been determined by a pro forma, an estimated projection of future cash flow calculated on spreadsheets, whose sole purpose is often erroneously seen as only to attract investment into the new venture. A pro forma analysis is the basis of the feasibility study and is a core component of the business plan for the biofuel or renewable chemical project. Lots of projects have a pro forma that shows a great ROI, which may give the entrepreneur a warm-and-fuzzy feeling, but no professional dealing with financing new technologies really cares much, because every failed project also had a high projected ROI. The critical factor is project risk, which is first evaluated from what lies behind the pro forma – the sources of the inputs and assumptions, e.g.: biomass consumption and cost, product output/yield and pricing, and operating costs. Ventures may hire prestigious accounting or engineering firms to prepare a more authoritative pro forma. While doing so may encourage investment, the accuracy of the inputs and, therefore, the forecasts, have not necessarily been improved. The pro forma analysis is only an initial screening tool for an investor or lender to quickly identify if a project is worth further consideration.

One contentious issue in pro forma design is what to include in the multi-year forecast. Project developers often promote building two or more facilities within a five-year period. With commercially proven technologies, this approach is important. However, with emerging technologies, such assumptions are foolhardy, and a warning sign that the challenges of introducing a new technology are not understood by the promoter. The most important indicator is the financial result from the first plant operating at capacity. One should take it for granted that if the first plant achieves an acceptable cash flow, other projects will be pursued, but the greatest risk is with the first project, and until that hurdle is overcome, future facilities are not worth considering in any detail.

Projected ROI is never as important as the entrepreneur thinks it is or should be. Why is that? A pro forma is not an accurate forecast of future returns from an emerging-biofuel technology; by definition, “accuracy” is not possible because of the many unknowns. Since the inputs are predictions and there is inherent uncertainty with them in the first place, actual results will vary materially from the forecasted financial performance. Consequently, the results of the pro forma are only an idea of what actual results could be if the inputs/assumptions hold true. Nevertheless, without the pro forma predicting at minimum an acceptable return (and enough cash for debt coverage), a project will not succeed (or get financing). The importance of absolute value of the projected ROI to an investor is directly related to the commercial maturity of the technology. In the concept stage, the ROI is almost meaningless, but for technologies where commercial-scale facilities are operating (and many of the inputs are from actual operating data), the ROI becomes a significant decision-making factor.

The pro forma for What-if Analysis

While the direct importance of ROI is variable, the pro forma, itself, is essential at all stages of development to the investor and the entrepreneur. Unfortunately, entrepreneurs behind these projects often miss the greater potential of the pro forma. Most pro formas for emerging-biofuel and renewable chemical projects are prepared only for investment purposes, but they can offer much more. Entrepreneurs (and early-stage investors) wish they had a crystal ball to predict the future, so that they can answer questions like these:

• How risky is the project?
• What is the fastest route to positive cash flow?
• Where should R&D and technology development efforts be focused?
• Is there a better way to spend limited resources?

The pro forma can be such a crystal ball for emerging-technology entrepreneurs and early-stage investors.

All pro formas, however, are not created equally. There are two basic types of pro formas:

• Static – the financial results are displayed only as values, or formulae with locked input cells (i.e., the user cannot change the input values). Although the fundamental information lies within a static pro forma, the results are restricted to one scenario by the design of the spreadsheets.
• Dynamic – a much more powerful business tool is the dynamic pro forma, where the financial results are displayed as formulae, which grab data from unlocked input cells (i.e., the entrepreneur can change the input values; if you want to see the impact on operating income of, for example, a 10% increase in any input [e.g., biomass cost, product pricing or product yield] a simple change of one cell will give the result).

The dynamic pro forma can provide a crystal ball into the financial future of a commercial process. It is also a living document, as inputs can be changed when new information becomes available, to conduct a What-if Analysis, or a sensitivity analysis. Simplicity also enhances the power of a dynamic pro forma; an input appears only once, often together with other inputs in a single unlocked spreadsheet, where all calculations are linked. A dynamic pro forma clearly illustrates how a financial result is determined, demonstrates the project risks, and defines the venture road map. In other words, the dynamic pro forma is a window upon their process and business. Therefore, while the pro forma may be designed by outside experts or someone else within the venture, the entrepreneur must take the time to understand the mechanics of the pro forma to take full advantage of this instructive tool. An added advantage is when the inevitable moment arrives that the entrepreneur is presenting the forecasted financial results of their project to a potential investor, they demonstrate a thorough understanding of what lies behind the project numbers.

This article is second in a series of articles by Lee Enterprises Consulting on moving through the investment process considering the needs of both the entrepreneur and the financing institution/investor. The next article will discuss the art of the business plan: Financing Bioeconomy Ventures: 3 – The Business Plan.

About the Author

Gerald Kutney is the Executive Vice President of Emerging Technologies, Biomass Power, Biogas/AD, and Investor Services for Lee Enterprises Consulting, and Managing Director of Sixth Element Sustainable Management in Ottawa. He has a Ph.D. in chemistry and over two decades of executive experience with global corporations and entrepreneurial enterprises in the forest bioeconomy.