We’ve blogged before about the need to step back and take a hard, cold look at whether your business plan will be attractive to bankers, lenders, and investors. This is particularly true for small private companies seeking investors, or those going public with an over-the-counter (OTC) issue.
Over the course of my career, I’ve personally seen the negative impact of the inability to access capital. For many businesses, it is a showstopper. Others carry on, although they have trouble financing much growth, and these can max out as “lifestyle businesses” — businesses that can provide the owner with an income sufficient for a good lifestyle but destined never to go beyond that point. If that is the owner’s ambition, fine… but those who want to take it to a higher level will probably need more capital than they can muster from family, friends, and credit cards. It’s a truism that the more you want your business to grow, the more cash you need.
So, our next few posts will be about how savvy investors evaluate business opportunities, so that your company can be more successful in attracting investors.
While novices often assume that the most important aspects of concern to investors are entirely financial, we think a decent financial outlook is just table stakes — a must-have — and that other factors can make the real difference. We’ll talk about this issue more in future posts, so let’s look now at what are considered to be the ideal financial characteristics of a new venture. If a new venture can’t meet these guidelines, it probably isn’t worth starting it. The same guidelines can be applied to existing businesses.
A quick aside here is about something that business owners and entrepreneurs sometimes overlook — no investor can take an existing business very seriously if it don’t have audited financial statements. It just implies that there is something to hide, especially if they already see evidence of desperate measures like capitalizing the office supplies in an attempt to boost profits. The best case is to have up-to-date financials prepared by a reputable accounting firm; the second-best is to either have an audit in progress or immediately agree to getting it done; and the least preferred situation is to resist making proper financial statements available. It won’t save any money in the long run if it prevents you from getting the capital you need.
Of course, start-ups without any operating history have to rely on projections. Your projections should be based on stated assumptions reinforced by industry benchmarks and market research.
Back to the numbers themselves. Jeffry Timmons, a former professor at Harvard Business School, Babson College and Northeast University (Dr. Timmons recently passed away), teamed up with another expert on entrepreneurship, Stephen Sinelli, to examine this issue. Sinelli brought real-world experience to the subject — he was the co-founder of Jiffy Lube who later earned a Ph.D. in economics and went on to become a business professor and director of the Arthur M. Blank Center for Entrepreneurship at Babson College. Together they wrote a popular textbook called “New Venture Creation” that is widely used at business schools. In their book they defined the following financial characteristics for a high-potential new venture.
First, the product or service must create significant value for the customer or end-user; meaning that it solves a significant problem and/or meets a significant need for which someone will pay a premium above the cost of providing, selling and delivering the product or service. This premium is, of course, PROFIT, and the profit potential should be high, at least 10% to 15% after tax. You’ll find a company’s profit on their income statement, also sometimes called the Statement of Profit and Lost (P&L) for just this reason.
Second, there must be attractive returns for investors, meaning an INTERNAL RATE OF RETURN of 25% to 30%. Technically, the internal rate of return — or IRR — is defined as the discount rate at which the net present value of an investment is zero. The net present value (NPV) is a discounted cash flow calculation. If your cost of capital (the return that capital could be expected to earn in an alternative investment of equivalent risk) is less than the investment’s IRR, then the NPV is positive and the investment is (in theory, at least) profitable. Where will investors find these cash flows? On the company’s income statement and statement of cash flows, sometimes called a statement of change in financial position. You’ll need an NPV calculation to determine your IRR.
Third, Timmons and Sinelli say the venture should generate strong and early free cash flow through a combination of recurring revenue, low assets and low working capital. Why is this important? Actually, it is closely related to the point above. Since a dollar today is worth more than a dollar tomorrow, near-term cash flows will contribute more to the net present value than the same cash flows longer out in the future. Ditto for larger early cash flows. And the more positive the NPV, the more favourable the IRR. Cash flow also allows the company breathing room, since it then has the financial ability to go beyond meeting its obligations and can use its profits to further reward investors and invest in more growth.
Fans of Dragons Den, the popular TV show where entrepreneurs try to persuade professional investors to invest in their ideas, will probably have see the dragons demand a share of revenue until their invetsment is paid back. That’s because the dragons want to gain strong and early cash flow on their investment, as well as reduce risk.
So, a little analysis is required to evaluate the financial characteristics of an opportunity. In practice, investors — or their financial analysts — also routinely calculate various ratios based on your financial statements to determine the health of your existing business. If you need help, you can ask your accountant or a corporate finance expert to see how your company stacks up.
THE BOTTOM LINE: Your company or start-up must provide credible financial statements that indicate a positive financial position or outlook. But you’ve only passed a potential investor’s first hurdle — not being screened out does not mean he or she is ready to write you a cheque. Tune in next week for part two.