To the Investor:
Perhaps the most important analysis that must be performed in the diligence process is analyzing the financial projections (P&L) of a potential investment. We have all heard about public company analysts and the ratios they use to evaluate a company’s performance (PE ratio, etc.). In private equity, we have little or no history to evaluate and the ratios used for public company analysis are almost meaningless.
So what do we do? We ask for five years of projections in the future. We all know that projections of a startup five years in the future are pure fantasy. But, that does not mean they are meaningless. This is where we find out if an entrepreneur can plan a business. Do they know how to create a reasonable budget? Do they know how to build a sales organization? Do they understand when they are going to need capital in the future? In short, the financials of a company are the single most important tool to understand the progress of a company in its quest to reach escape velocity and create wealth for the founders and investors. If your entrepreneur does not have a five year proforma, the company is not ready for investment. Have them take the attached template and create one. This is an excellent opportunity for mentoring an aspiring entrepreneur.
The old rule-of-thumb was to cut the revenue in half and double the expenses. If you still like the venture, then proceed. That is as unscientific as it comes, and we can do better.
First, let’s tackle the easy part, the L side of the P&L. Expenses are easy to project if you have ever run a business before. There are predictable expenses (aka Total Operating Costs) and they can be explicitly entered or modeled to create a proper financial projection of what it will cost the business to buy revenue or users (that is what we are doing after all):
- G&A including salaries and benefits, legal, accounting, insurance, professional services, etc.
- Operations and Expenses including hardware, software, office space, phone, furniture, Internet access, printers, etc. and travel (that can be either expensed, amortized, or depreciated)
- Marketing and Sales including advertising, trade shows, SEO, trade association memberships, travel, etc.
These should be reviewed for feasibility. The question you must answer is does the entrepreneur understand how to budget and project the cost of scaling the business?
It stands to reason that a good CFO should be able to project the overhead of each employee as it grows, good engineer should be able to project the cost and process for product development, and a seasoned CEO should be able to bring the project in on budget and on time. So, why does it cost 2 times as much and take 2 times as long as projected? The short answer is challenges of finding timely and adequate funding.
A good team with the right capital should be able to meet its projections on time and budget, but they RARELY, bordering on never, have the ability to do so. Raising capital is a time consuming and painful process and startups must search for and find capital where they can. It is a laborious and tedious process that is repeated ad-nauseam, over and over, and with great redundancy.
To get one interested investor, you need to pitch five. To get one committed investor you must pitch 3 interested investors. So, the net is 1 investment for every 15 investors you pitch. Historically this was the challenge facing any CEO. This often leads to a stop-start-stop-start product development process that only extends the time and the cost of product development. The upshot of all this discussion is any projection of expenses should be padded with working capital. Without working capital, you are investing in a high-wire act with no net. Make sure there is room for inevitable errors and make your entrepreneur point out where the likely problems will come and how he/she will mitigate them (See ACG Manifesto for more risk mitigation strategy). As an aside, this is one of the many reasons we created the Alliance to efficiently get capital into the hands of deserving entrepreneurs so they optimize their product development, product launch, and revenue generation.
Now, let’s move on to the P side of the P&L. Projecting revenue is the challenge! The one thing we know about all financial projections is they are wrong. That is the only thing we can say with confidence about them. Experience tells us that the actual performance will be wildly different (unfortunately, lower is the mode) than projected. So, how do we really evaluate them?
- Financial projections are the numerical version of the business plan. Make sure they are in lock-step. Assumptions should match. Key milestones should match. The cost of scaling should be adequately accounted for, and a meaningful capital plan should be in place.
- Find market studies to confirm the size of the market opportunity. Pay particular attention to the segmented market to which the company has pointed its “beachhead” strategy.
- Find comparable companies and benchmark at their performance.
- Examine the model in depth to make sure the math all works!
The sole reason a P&L works is the projection of revenue. We are all tired of seeing “hockey-stick” growth curves with no substance behind them. So, hold your entrepreneur to a high standard in this regard. There are three ways to project sales:
- Wing It! – the entrepreneur has simply plugged-in numbers that look good and create the proverbial hockey-stick. Clearly, if you see this approach, run. This entrepreneur has not done his homework, does not understand how marketing and sales work, and does not have respect for your intellect.
- Sales Cycle Based – the entrepreneur creates a model where marketing creates X leads that are given to the sales people who can manage Y accounts with a Z percentage closing rate at W cost per unit. In this case, the number of sales people drives the revenue projection. This means the entrepreneur understands how marketing and sales work and has managed a sales process before. This is acceptable, but not optimal. It still does not name names to directly address the value proposition of the company – why a given client will buy, how many they will buy, and at what price.
- Pipeline Based – in this model, the entrepreneur demonstrates his knowledge of the industry and his sales contacts and has already created a sales cycle that assigns a probability of closing based on the steps in the sales cycle (e.g. an RFP from the company means a 50% probability of closing in X months, etc.). This is used to drive the Sales Cycle Based model above. In this case, the entrepreneur names names and gives odds of closing over a given time frame. And, that is a pretty handy piece of information to have! This entrepreneur has done the right homework and is ready to take your capital to market to buy revenue or users.
The last example is the most beneficial to the investor because you can walk through the pipeline and evaluate why a given client will buy the product. And, you will be surprised to find that through the network, you will often find a connection into those companies in order to verify the client’s pain-point the entrepreneur believes he is addressing. One word of caution, you must be careful not to disrupt the exchange between the entrepreneur and the company.
The final step is to review the projections with an eye toward accuracy and scalability:
- Can the company scale as quickly as the entrepreneur projects?
- How many people are required to operate a business scaling at that speed. Remember, Google makes $1M per employee. So, if a company projects $100M in revenue in two years, they need a plan to hire 100 people over that time frame!
- Are the clients in the pipeline real?
- Does the entrepreneur understand the sales cycle of the industry?
- Can you verify the pain-point of the projected client base?
- Are they projecting enough marketing expense (how will it be spent, how are they capturing leads, and how will they manage these leads?) to reach their clients in the industry? Going “viral” is not a strategy. Typical conversion rates for internet/social media campaigns are below 2%. So, predicting the cost of user acquisition is a key question that is based on the cost of key words, the cost of add buys, ability to precisely target clients, etc. Your entrepreneur should understand the cost of user acquisition for his market segment. If not, he/she has not done the right homework.
There really are few if any real “metrics” or ratios you can use to evaluate an early stage, private equity company. That is why we focus on the entrepreneur, the team, and their past performance, which is admittedly not a good predictor of future performance. But, it is all we have to go on. Don’t be shy about questioning the financials. And, make sure the entrepreneur knows you will be expecting periodic (monthly or quarterly) updates on the company’s performance against these projections, which should be turned into a budget. As the financial reports roll in, hold the entrepreneur accountable to that budget that becomes the management team’s authority to operate (proper Board of Directors governance!). Identify where they are over budget, find out the root cause. These portend future problems before they become problems. Deal with them in a heads-up fashion. Revise assumptions an plan accordingly.
At the end of the day, what we want to determine is do the projections make sense? Do they capture the cost of scaling the business accurately? Do they really reflect the market opportunity? Does the team have a proven track record in marketing and sales? Time invested in answering these questions is very likely the difference between a good investment and a bad one.
This was originally published under the Appalachian Regional Commission POWER Grant, PW-1835-M.
Copyright Appalachian Investors 2017
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