As we discussed in our previous posts, if your company can provide credible financial statements that indicate a positive financial position or outlook, you’ve passed a potential investor’s first hurdle. Explicitly, that means:
- the profit potential should be high, at least 10% to 15% after tax;
- a high internal rate of return, ideally 25% to 30%; and,
- strong and early free cash flow through a combination of recurring revenue, low assets and low working capital.
Existing companies can demonstrate their ability to meet these criteria by providing investors with audited financial statements. They have some success that they want to build on.
But what’s a start-up to do?
Unfortunately, a start-up has to rely on pro forma statements — projections based on industry averages, benchmarks, and other comparables, all held together with (hopefully) reasonable assumptions documented in a well-thought out business plan. But there is always uncertainty.
Two additional numbers — graphs, actually — help investors assess the uncertainty of a start-up, and think about risk and reward.
What is often called dead weight is the amount of cash that needs to be injected into a business before it starts earning a positive cash flow. This is the amount that you and your investor pool collectively need to invest and put at risk.
Consider a graph of monthly cash flow plotted against time. Initial start-up costs will usually create a large negative cash flow that extends below zero (the X-axis) for the first several months. We would expect that monthly cash flow will become less negative with time until the break-even point is reached. At break even, the curve hits the X-axis, and should continue into the positive above the X-axis. Such a graph visually depicts three things:
- how much “dead weight” the volume of the negative cash flow represents;
- how long it takes to break even; and,
- how quickly the positive growth is.
This is why investors are usually persistent in their efforts to verify that the claimed start-up costs are accurate; under-stated start-up costs reduce dead weight. You don’t often see this graph in business plans, because it makes marginal investment situations brutally clear.
A second way to assess risk is to consider the likelihood of achieving different possible returns, ranging from a total loss (-100%) to a big hit (+200%). The shape of the curve formed by plotting IRR values against their probability shows investors what category of risk they face — are they being asked to gamble on a highly-speculative venture that has a small chance of paying off big, or a conservative venture that could make a modest return but probably won’t lose their capital?
This sounds hard to do. And it is, particularly for tech start-ups creating new or emerging product and service categories for which relevant industry history and close comparables don’t exist.
If your new company was going to make the first DVD player, you could base your business plan on the VCR market. Lots of information was known about the VCR market — its size, manufacturing capital requirements, returns, pricing, buying behaviour, distribution requirements, etc. And a semiconductor firm coming out with a new generation of chips can base their plans on their previous experience. But if your start-up wants to offer something completely new — say, vacations at the first resort on the moon — you won’t have much to go on.
THE BOTTOM LINE: Start-ups need to help investors assess risk as well as reward. And since their new venture doesn’t have any operating history as proof, this wil be difficult.
Just for keeners: You can find out more about these two risk assessment techniques in William Sahlman’s classic HBR article called “How to Write a Great Business Plan” (Harvard Business Review, July-August 1997).