Financial Modeling for Operations: Part 3 – Capitalization in Finance

If you haven’t already, check out the first and second installments of of this series where I shared the first three key initiatives in optimizing customer acquisition and growth: the growth plan, the revenue plan, and the expense plan.

In this third and final portion of our series, I will discuss the details of the capitalization plan within the context of our quarterly timeline to measure Objectives and Key Results (OKRs). I will wrap up with best practices for your team’s quarterly OKR strategy sessions that we have been discussing throughout the series.

What is Capitalization?

Capitalization, in a broad sense, refers to the total amount of a company’s debt and equity used to fund its operations and growth. It represents the company’s financial structure and is a key indicator of its financial health and potential for future growth. In simpler terms, capitalization is the total amount of money that has been invested in a company.

What are the Types of Capitalization?

Accounting Capitalization

In accounting, capitalization involves recording a cost or expense as an asset on the balance sheet rather than immediately recognizing it as an expense on the income statement. This process is based on the principle that certain expenditures provide future economic benefits and should be spread over their useful life.

Examples:

• Tangible Assets: Machinery, buildings, and equipment.
• Intangible Assets: Patents, trademarks, and software development costs.

In 2016, the Financial Accounting Standards Board (FASB) introduced a new Accounting Standards Update (ASU) mandating that leases longer than twelve months must be capitalized as an asset and listed as a liability on the lessee’s balance sheet. This ensures an accurate representation of both the lease’s rights and obligations

Finance Capitalization

In finance, capitalization refers to the market value of a company’s outstanding shares of stock. This is often referred to as market capitalization or market cap. It is calculated by multiplying the current share price by the total number of outstanding shares.

Formula:

Market Capitalization = Share Prices x Number of Outstanding Shares

Example:
If a company has 1 million shares outstanding, and the current share price is $50, its market capitalization would be $50 million.

What are Capitalization Thresholds?

Capitalization thresholds are predetermined dollar amounts that dictate whether a particular expenditure should be capitalized or expensed. These thresholds help in maintaining consistency and ensuring that minor expenses are not capitalized unnecessarily, which could complicate the financial statements.

Factors Influencing Capitalization Thresholds:

• Company Size: Larger companies might have higher thresholds due to their substantial assets.
• Nature of the Asset: The expected useful life and the potential for future economic benefits play a significant role.
• Industry Standards: Different industries may have varying practices and guidelines for capitalization.

What Does Capitalization Mean in Accounting?

In accounting, capitalization is a process that involves treating a cost as a long-term investment rather than an immediate expense. This means that the cost is added to the balance sheet as an asset and expensed over the asset’s useful life through depreciation or amortization.

Key Points:

• Depreciation: The systematic allocation of the cost of a tangible asset over its useful life.
• Amortization: Similar to depreciation, but it applies to intangible assets.

What Does Capitalization Mean in Finance?

In finance, capitalization is a quantitative assessment of a firm’s capital structure. It represents the total amount of a company’s long-term debt, stock, and retained earnings. This measurement is crucial as it provides insight into how a company finances its operations and growth through various sources of funds. There are two primary forms of capitalization in finance:

1. Book Value Cost of Capital: This refers to the total value of a company’s long-term debt, stock, and retained earnings as recorded on the balance sheet. It represents the historical cost of all the funds that have been invested in the company.
2. Market Value or Market Capitalization: This is the total market value of a company’s outstanding shares of stock. It is calculated by multiplying the current share price by the total number of outstanding shares. Market capitalization reflects the market’s valuation of a company’s equity and is a key indicator used by investors to determine a company’s size and investment potential.

What is a Capitalization Plan? 

A capitalization plan details a strategy to ensure the company doesn’t run out of money. This plan includes target dates and specific cash amounts for raising debt, equity, or a hybrid of the two. 

Just as with the other three key areas, the capitalization plan serves a critical purpose for founders in establishing quarterly goals, measuring actual results, and executing pivotal changes toward maximizing growth opportunities.

In the last section, we discussed how the expense plan should detail what is spent over the immediate quarter and foreseeable future. Within the hiring plan, we set specific goals toward hiring a sales team and other staff members to achieve growth. Using our quarterly timeline to set goals and measure results, each area of our financial model communicates the company vision and demands accountability from the team. The capitalization plan is no different. We will set clearly defined targets for cash to raise and detail company actions to prepare to close each rounds. Take a look at the below example of our capitalization plan.

In this example, we plan to close our $1M seed round at the end of June — our first OKR.

As our team reviews the model leading up to Q2, we understand the immediate need to focus on final tasks for closing out the fundraise in order to hit this OKR. This may include getting out wiring instructions or following up to ensure our cash hits the bank account.

Beyond the immediate quarter, we will also outline a structured vision for future capitalization. In this next example, I have outlined a Series A round, perhaps 12-18 months in the future. These high level targets lay critical groundwork to plan effectively and set company vision on the next significant milestone. Even more, in outlining these long term objectives, we are poised to perpetually adjust strategy and propel forward as goals change against growth.

OKR Strategy Sessions

By this point in the series, you understand my familiar mantra: forecast, analyze, optimize. Outlining a plan is futile without look in the rear view mirror to understand our shortfalls and tweak our strategy. Without accountability, goals are meaningless. So, what exactly does this process look like?

In the example below, we have measured our actual quarterly data against our forecasted data for the last quarter and the upcoming months.

This portion of the financial model forces our team to perform a forecast versus actual analysis each month, which ensures (1) we deeply understand our business performance in real-time metrics, and (2) we can catch opportunities for improvement before they snowball into cashflow crisis. Did we receive a huge legal bill last month? Was churn higher than anticipated? Is our sales team not performing against expectations? The team must be able to research and explain the root cause behind data-based realities that cause ripples in your growth goals before they cause a tidal wave. Monthly OKR reviews provide the necessary cadence and accountability to consistently move the needle toward success. Additionally, the side-by-side comparison allows us to understand if our forecasted goals are truly attainable.

To fully reap the benefits of your financial model in operations, we need to understand the cadence of these interactions.

Like I mentioned in the first part of this series, we will lock down a version of our plan each quarter for each key area (growth, revenue, expense, and capitalization); each quarterly plan defines our OKRs for those three months.

Throughout the month, we will set strategy meetings with the team to review and track progression toward these goals — I recommend meeting no more than 30 minutes once a week to track progress, while planning for one longer deep-dive session at least once a month to understand each abnormality and rethink strategy as needed. This not only keeps the team focused on priorities, and but also empowers the team to achieve each milestone in the context of long-term vision.

Your monthly deep dive meeting could be one to two hours long as you delve into detail on your growth, revenue expense, and capitalization plans. On the Forecastr team, these mandatory OKR meetings involve full team representation to enable comprehensive troubleshooting on any growth abnormalities and ensure unified buy-in on new strategy. We will carefully compare our forecast versus actual performance to stay on top of the metrics and avoid a surprise cash shortfall.

As I keep emphasizing, these meetings demand accountability from the team as we dig into the growth plan and discover who hits the targets and who falls short.

After the deep dive, I highly recommend sharing your key metrics with investors, mentors, and other employees in who are not directly involved in the meetings. Sharing creates transparency with your investors, which builds trust in your relationship. Your mentors may be able to provide insight into your key metrics, such as potential trends or growth opportunities the team may overlook. Sharing with your employees promotes team engagement and allows buy-in from the whole organization.

Most pivotal of all, at the end of the quarter, we will use our actual data comparison to create change, adjust goals, and cut ties with inefficient growth strategies. Customer acquisition drives the groundwork for growth. As founders, herein lies our opportunity to identify our vision and innovate our brand through a financial model.

Conclusion

Understanding capitalization in finance is essential for startups and growing businesses. It helps in determining the optimal mix of debt and equity, ensuring long-term financial health and sustainable growth. By effectively planning and executing capitalization strategies, companies can secure the necessary funds to fuel their operations and expansion.

If you’re looking to build robust financial models that accurately reflect your company’s capitalization needs, Forecastr.co can help. Our team provides comprehensive financial modeling software tailored to your specific requirements. Contact us today to learn how we can support your financial planning and growth objectives.