This article is the ninth in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
Raise your hand if you’ve ever been in this situation: You meet with an entrepreneur, and his pitch is awesome! The team is great, the product is great… everything is great. Except, the team is seriously deficient when it comes to understanding finances.
You were ready to write a check. But you are a thoughtful investor who doesn’t make quick decisions just based on gut feeling. So you put your checkbook away and commit to some serious financial due diligence. It’s time to roll up your sleeves, pull out the green eyeshade and dig into the financial plan and funding strategy for this awesome new company.
Those of you who aren’t numbers people are probably tempted to skip this article. You should read on, because you really need to know this stuff or I promise, it will come back to bite you! That said, if you truly aren’t into understanding a company’s finances, make sure you have someone on the due diligence team who is.
Even though I spent some time as the CFO of a public enterprise software company, it is Ham who is the financial genius at Launchpad and Seraf. He does all our financial planning and is on the audit committee for several company boards. So he really digs this financial stuff. Why, I don’t know.
Q: Ham, we have a lot of ground to cover, so let’s jump right in. What’s the first thing you look for in a company’s financial plan?
Behind every solid financial plan, I expect to find a rationally thought out and verifiable set of key assumptions. Many start-up founders assume growth is the answer to all their financing problems, but anyone with a little financing experience knows that growth does not produce cash, it consumes cash. The assumptions in a solid financial plan should take these realities into account. They should be reasonable and not in conflict with core elements of the business plan and the market being served. For example, the unit price for the company’s product should be within reason. So if the company projects a $1000 unit sale price for their product and the competition sells their similar product for under $10, you will need to ask some questions as to why there is such a significant price differential.
Different industries have very different key assumptions that drive the financial plan. That said, there are a core set of assumptions that all plans should be based upon. Some of the key assumptions made in the preparation of financial projections should include:
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Is the company’s long term funding plan connected to specific milestones such as first prototype, Beta test completion, FDA approval, pilot production, First Customer Ship (FCS), etc.?
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When will the company reach cash flow breakeven/positive and how much funding will be required to reach this point (remembering that driving growth consumes cash)?
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Have unit sales volumes been tied to rational sales cycles and seasonality?
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Are market penetration rates consistent with the market sizing and competitive conditions shown in the Business Plan?
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Do Average Sales Prices (ASPs) link to market comparables and anticipate future competitive pricing pressures?
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Is gross margin as a percentage of revenue what you would expect to generate for this product when stacked up to market comparables?
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Have projected staff salaries been derived from current market/labor conditions?
Q: Most entrepreneurs include a section in their presentation on amount of financing they are raising and the use of proceeds. What do you look for here?
Near the end of the CEO’s pitch to investors, they always ask for money. And, in most cases, they give a very high level overview of where the money will be spent. A typical presentation might break the spending down as follows: (40% for engineering, 30% for sales and marketing, and 30% for operations).
That’s a start, but you need to know more. After you’ve examined the key assumptions in the financial plan, the next step is to dig into the use of proceeds. First and foremost, you should understand what milestones will be achieved with the proceeds from the financing. Let’s look at two examples:
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A medical device company is raising $500K. With this financing, the company expects to build a prototype of their product and start initial animal testing.
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A software company is raising $1.5M. Their product is built and they already have their first customers. With this financing, the company expects to grow to $200K in Monthly Recurring Revenue (MRR) and to approach Cash Flow Breakeven (CFBE).
I like to see a monthly financial plan that provides realistic expenses that result in meeting these milestones. That tells me that the CEO (and her team) understand what it takes to move the company to the next stage. But, we’re not done yet. You need to take it one step further. You need to understand how significant those milestones are. Here are a couple of the questions you should ask:
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Will this increase the value of the company and the investment I am going to make?
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Will new investors be interested in continuing to finance the company, and help it reach its ultimate goal of a successful acquisition or IPO?
If you can’t answer these questions in the affirmative, you have some more work to do. Maybe you need to convince the CEO to lower the valuation on the company. Or, maybe you need to help the CEO raise even more capital so the company can achieve an even greater set of milestones.
Q: As an investor and a board member, understanding a company’s financing strategy is critical. Before you make an investment in a company, what do you need to know about a company’s funding plan?
As an early stage investor, my concerns are different than later stage investors. Once I am comfortable with the Key Assumptions and Milestones, I move on to explore two additional areas:
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In the near term, how much runway does the company have before it runs out of cash?
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In the long term, how much capital will the company need before an exit?
To answer the first question, I look at a detailed monthly P&L statement along with the cash flow statement. I want to know as accurately as possible how many months the company can operate before cash runs out. And, I want to make sure that period is long enough to allow the company to achieve the key milestones we agreed upon earlier. If it’s not enough, then I will work with the company to raise more capital than they originally set out to raise.
For the second question, I am trying to figure out how much financial risk I am taking by making this investment. If the company only needs to raise a small amount of money before an exit, I can reduce financing risk to a minimum level. On the other hand, if the company will need to raise $20M+, I am taking on significant financing risk with my investment. I will need to plan accordingly by reserving a larger amount of my investment capital for future rounds of financing. And, finally, I may need to make many introductions to bigger venture investors to ensure that the company can raise what it needs to succeed.
Q: We’ve discussed many of the high level issues relating to a company’s finances. Let’s dig in a bit deeper. What are some of the critical secondary issues that investors should understand?
When you invest in a very early stage company, there aren’t that many financial issues that come back to bite you. Sometimes, I do invest in companies that have a bit of history and have been in business for more than a year or two. If that’s the case, then I tend to dig a bit further.
It’s not unusual for a startup company to defer payments with a number of their vendors, including lawyers and suppliers. So as part of our diligence, we will ask to see their balance sheet and make sure that both AP and AR are well documented. In most cases, these items will be covered by our attorneys in the closing documents’ disclosure schedule. And, don’t forget to make sure that the founders aren’t expecting any back pay or repayment of credit card debt, unless you’ve fully bought into these payments!
Q: What if they have a great business opportunity but need serious help on pulling together their financial plan, what do you do?
That’s a pretty easy question... I point them in the direction of a great CFO! We are fortunate in the Boston area to have access to many successful CFOs who are willing to work part time for startup companies. In the early days, startups might need a CFO for a day or two a month. During fundraising periods, that need might increase a bit. As a CEO, you are crazy not to make use of this valuable resource. A CEO might not value this skillset as highly as they do a great engineer or marketer, but never underestimate the value of a well thought out financial plan.
Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
