By Dr. Gerald Kutney
When you first talk with an early-stage technology biofuel entrepreneur or project promoter, the first thing that you hear about their project is that it has a good return on investment (ROI). The ROI has been calculated by a pro forma, an estimated projection of future cash flow calculated on spreadsheets, whose purpose is often 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 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 that deals with financing new technologies really cares that much, because every failed project that they invested in had a high ROI, according to a pro forma. 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. Project risks stem 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, energy demand and costs, labour costs). The pro forma analysis is only an initial screening tool for an investor or lender to quickly identify if the new-technology project is worth further consideration.
A contentious issue of pro forma design is what goes into the multi-year forecast. Project developers of new technologies can promote building two or more facilities within a five-year period. With emerging-biofuel technologies, such inputs are (often) foolhardy, and are a warning sign that the challenges of introducing a new technology are not understood by the promoter. The important aspect is the financial result from one 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 this hurdle is overcome, future facilities are not worth mentioning.
The 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 the them in the first place, the 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 least, an acceptable return (and enough cash for debt coverage), a project will not succeed (or get financing).
The pro forma of many emerging biofuel projects are prepared only for such important investment purposes, but they offer much more. Unfortunately, entrepreneurs behind these projects are missing the greater potential of the pro forma. 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 be spending limited resources?
The pro forma is such a crystal ball for emerging biofuel entrepreneurs and early-stage investors.
All pro formas are not created equally. There are two basic types of pro forma:
- Static – the financial results are displayed only as values, or formulae with locked input cells (i.e., the entrepreneur 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).
The dynamic pro forma is a crystal ball into the financial future of a commercial process, and it is a living document, as inputs can be changed when new information becomes available, to examine a What-if Analysis, or to perform 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 was determined, demonstrates the project risks, and defines the venture road map.
Gerald Kutney is a member of Lee Enterprises Consulting. Lee Enterprises Consulting is the world’s premier bioeconomy consulting group, who have consultants and experts worldwide, including the design and analysis of dynamic pro forma and related feasibility studies and business plans for entrepreneurs and investors. The opinions expressed in the report are those the author, and do not, necessarily, express the views of Lee Enterprises Consulting.