What financials do we need for investors?
Discussions About Preparing Financials For Investors
Professor William Sahlman writes, “Entrepreneurs are value creators, investing today in hopes of generating cash flows tomorrow.” So the main purpose of the financial section of a business plan is to formulate a credible, comprehensive set of projections reflecting a venture’s anticipated financial performance.
Therefore, if your projections are carefully prepared and convincingly supported, they become one of the most critical yardsticks by which your venture’s attractiveness is measured by potential investors. Since the value of your venture ultimately depends on what the business will accomplish in the future, reasonable estimates of future cash flows will help in arriving at a value. So when a venture team produces convincing financials it will likewise command a higher value than one that does not!
But what exactly are financial statements? According to the American Institute of Certified Public Accountants (AICPA), the term financial statements refers to a package of financial data, including accompanying notes, derived from accounting records. They are intended to communicate an entity’s resources or obligation at a point in time, or the changes therein for a period of time, in accordance with a comprehensive basis of accounting.
Four traditional financial statements, along with the assumptions and notes, together comprise the financial statements of a business entity. They are Income Statement, Balance Sheet, Statement of Cash Flows, and Statement of Stockholder’s Equity. Although there are no true ground rules for levels of preparation in the venture capital industry, accountants prepare financials to one of the three levels.
– The first, “audited financials,” are prepared for publicly traded companies and prepared by independent auditors.
– For the second, “reviewed financials,” the accountant expresses limited assurance; the accountant might or might not have been aware of all significant matters.
– The third, “compiled statements,” are management’s representation presented in the form of financial statements; the accountant has not undertaken any efforts to express assurance on the statements.
Pro forma financials are simply projected financials. The exercise for completing your pro forma financials should not be about demonstrating Excel spreadsheet skills. Your pro formas should accurately support the storyline you are creating in your business plan. Practice on building financials from the ground up, using the market potential and feedback from lead users and key customers, to describe your upside.
Many times financials are done through a “CFO” mindset, using an artificial linear model to make projections. These tend to result in the infamous “hockey stick,” where the revenues are flat for a period of time, then launch in a perfectly straight line at a 45-degree angle. In reality the start-up process is very lumpy, not linear. It is not that the CFO or CPA doing the numbers is wrong; what’s wrong are the thought process and assumptions underlying the numbers.
Below we discuss the financials that investors need to see in a business plan, and we have provided additional guidance in other resources here. Be careful with your financials and keep them limited to supporting only your storyline. As Johann Wolfgang von Goethe once said, “The first sign we don’t know what we are doing is an obsession with numbers.”
Pro Forma Income Statement
We repeat what John Nesheim wrote in his book, High-Tech Start-Up: “Remember that cash flow and ROI (return on investment) are the measure of success for the venture capitalist.” Your pro forma income statement is based on your cash budget table, integrated with your sales forecast and your growth strategy. For most VCs, you will need five-year projections and a very detailed (sometimes week-by-week) cash budget table for the first year.
Be advised that getting your “gross margin” nailed down is most important. It demonstrates and presents the true value of your product to the customer. The investors do not just expect to see some huge top line sales numbers, but they do want to see how you determined the revenue model and how you discuss the soundness of your assumptions behind the gross margins.
We want to briefly discuss the “break-even” analysis, which is a financial exercise to determine some point in the future when your volume of sales neither makes a profit nor incurs a loss. It is that point in time when the next unit to be sold will contribute to profitability. This analysis originated in the academic world, mostly based on the research in consumer products, such as Procter & Gamble selling bars of soap from established production lines, through established sales channels, to an identifiable base of consumers.
In other words, the break-even analysis works great on linear assumptions where the financial models are sound and the research supporting the sales forecasts is solid. We repeat, for all early stage ventures, that the cash flow will move in lumps, and quite often the financial modeling will be adjusted on the go. Sorry, but your financials cannot be formed and compressed into one nice, neat algebraic formula at this time.
Pro Forma Balance Sheet
Although a pro forma balance sheet should be included, it will not be a primary concern for venture capitalists unless you have high inventory needs, large current liabilities like accounts receivables, or unless you anticipate capitalizing a large amount of R&D. More of a formality, it shows retained earnings, how the venture is being financed along the way, and what types of assets are being purchased. If you have any debt you will need to address the principal terms of the debt, type of debt securities, interest rates, repayment installments and prepayment terms, convertibility of the debt, subordination, affirmative and negative covenants, defaults or material breaches, and security or collateral used in the notes. Finally, if you are expecting to purchase other companies along the way as a part of your growth strategy, the balance sheet should reflect the consolidation of the ventures and the goodwill.
Statement of Stockholders’ Equity
Commonly referred to as the “Cap Table,” or “Capitalization Table,” it is a list of equity owners that includes each owner’s name and usually the number of shares held by each as of the valuation date. It details your capital structuring and demonstrates how you intend to fund your growth through selling equity. Investors need to know the details of your intended distribution of ownership, cost per share, and types of securities issued: preferred stock, common shares, warrants, and option pool projections for sharing with new employees. Family members and other relationships among the equity owners should be identified in the endnotes.
Also called “Use of Proceeds,” this can be a simple one-page document that clearly articulates your financing plan. It demonstrates the effect of investors’ money on the venture. As for restarts, it is perceived in the VC community that entrepreneurs who have been baptized by the fire of failure tend to have better understanding and appreciation for new business venturing, especially when it comes to financial management. If you have made some mistakes, fess-up to your foibles and carefully explain what you learned.
However, the best insurance plan is to avoid financial trouble, or at least have a strategy in place to help minimize the painful consequences. For restarts, you just need to have a good understanding on where the venture is, how it got there, and some plan of corrective measures.
Types of “Use of Proceeds”
1. Early Stage Financing
– Engineering The Runway. Relatively small amounts to conduct research, prove concepts, and finance feasibility studies. Also to complete product development, initial marketing, and organize venture team.
– Constructing The Runway. Focusing on getting to the “proof-of-concept” with the product, working capital for test marketing. Includes expenses for patent and intellectual property protection.
2. Development or Expansion Financing
– Accelerating to Full Throttle. There is proven market acceptance, here is heavy investment in marketing and sales. Includes working capital for initial capital equipment required for the putting the plan to action. And includes creating partnerships with major contracts or customers, and seeding the executive management team.
– Building Production Facilities. Investments for scaling to meet the future needs with the majority of the market. The big orders are not only coming in, but they are getting even bigger! Cultivating strategic partnerships around the world, and leading/nurturing the ecosystem.
– Getting Key Branded-Executives. Completing out the venture team and completing the transition from entrepreneurial management practices to professional management practices. Here, shifting the fulcrum from development to execution.
3. Acquisitions and Buyout Financing
– Buying-Up Capacity. For buying up competitors, facilitating quick expansion, scooping up executive management teams at weakened competitors. Also used for buying-up partners for national expansion plans, and/or establishing beachheads in global markets.
4. Restarts and Subsequent Rounds
– Extending The Runway. Sometimes even moving the runway, or creating a temporary runway on a new location utilizing a new business model, new products/new technology platform. Sometimes to salvage operations in order to sell-out. More often, for resetting and recharging the executives’ option pool too, when the venture is in a down round and exposed to “cram downs” in valuations.
Assumptions and Notes
Finally, know that investors expect to see financials that are supported by thoroughly documented assumptions and detailed notes. Because there are many decisions that management makes with respect to operating an early stage venture, your assumptions and notes not only give potential investors the data they need to evaluate your deal, but more importantly they speak volumes about how you arrived at your assumptions. They can be listed separately on a page as endnotes to the financials or included as footnotes to the financial statements and budgets.