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Every pitch deck has a financial projections slide showing that in 3–5 years the company will have millions or tens of millions of dollars in revenue and be profitable. Those projections come from a financial model built on a set of assumptions about growth rates, customer transaction size, customer acquisition costs, attrition rates, and others more specific to the type of business.*
The model and the assumptions will be very specific to the type of business. Especially in B2C businesses, the profitability will be very sensitive to some of those assumptions. Any of the pirate metrics mentioned above will likely have big impacts on profitability. The entrepreneur should be able to defend any critical assumptions in the model by pointing to comparable businesses. For B2B businesses, some of the critical assumptions will be conversion rates in the sales pipeline we mentioned above, attrition rates (how many customers don’t renew their contracts), length of the sales cycle (impacts growth rate and cost of customer acquisition), contract size, and how much revenue a single salesperson can generate.
Ask for a copy of the model and work with it until you understand what the key drivers of growth and profitability are. Test the impact of the key assumptions:
What if the conversion rate of customers upgrading from free to paid is 2% instead of the assumed 5%? Does the business become wildly unprofitable?
What if the transaction size is $50 instead of $100?
What happens to profitability if the attrition rate is 15% a year instead of the 5% represented in the model?
What if it takes on average six months to close a big customer instead of three?
founder Another thing to check in a financial model is how the entrepreneurs are thinking about staff growth. Pete has seen B2B models where the number of customers grows 100X over three years, but the operations and support staff only double. If that seems optimistic to you too, you can plug in a few more headcount to some of those functions, grow the engineering staff to account for product complexity and support, and see how far out that pushes profitability.
Many venture capitalists will build their own financial models from scratch to make sure they understand the drivers. If you can’t get the model from the founders or it is too convoluted for you to be able to test the assumptions, then you may want to build a simple one yourself. Remember entrepreneurs may not be experts at financial modeling, which is fine, but you don’t want that to lead you to a poor investment decision.
important At the end of the day, it is important to keep in mind that three or four-year financial models almost never pan out per the plan. The most common scenario is that sales and/or profitability progress more slowly than the plan projects. What you are checking for when doing diligence on these models is two primary things:
Does the entrepreneur have a realistic idea about what will drive the unit economics (how much money does each customer make or lose for the company under a given set of assumptions) and what revenue level and cost structure are required to be profitable overall?
If things do not turn out like the rosy assumptions in the model, does it just take slightly longer to become profitable, in which case it means the company has to raise more money than expected over time and you will have a lower return on your investment; or will it be a complete financial disaster requiring some change of course and much more risk?
You should also look at a company’s financial statements. For one thing, you want to make sure that they don’t have a lot of debt that has to be paid or a large accounts payable list. If they owe tens of thousands of dollars to prior contractors for engineering or design or legal work, then your investment may go toward paying old debts rather than moving the company forward.
You may also discover that there were prior employees or founders whom you will need to dig into on the legal side. You will want to make sure that the company has been paying any taxes, especially payroll taxes. Looking at the financial statements will also help you get a handle on the company’s burn rate.
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Burn rate is the amount of money a startup is spending every month. For a startup that is pre-revenue, this is considered the “monthly burn.” For a startup with revenue, the burn rate is the monthly spend less any reasonably expected revenues.
caution If a company that has been around for a year or more and is not using the services of an accounting firm or has not engaged a part-time CFO or equivalent service, that can cause some heartburn on the part of angels. It may be difficult in such cases to get financial statements to understand where they stand in terms of any existing financial liabilities or to get a handle on their ongoing expenses. We will talk more about why this is important below in the following two sections.
It is important to understand whether a company is about to run out of money or not—and, when you are putting new money in, how long that money will keep the company going.
In startup lingo, runway refers to how much time in months the company has before it runs out of cash, calculated by dividing the amount of money they have in the bank by the burn rate (the amount of money they spend each month). For example, if the company is spending $25K a month and has $100K in the bank, it has four months of runway left.
Raising money is very time consuming, and a company should always raise enough to keep it going for at least a year, preferably 18–24 months. Due diligence on the financial statements should get you the figures you need. Keep in mind that the burn rate often increases after a company raises money. They may hire additional personnel, or the founders may start to take a small salary, or they may increase their marketing spend.
Use of Funds
It is worth understanding how the company is planning to use the money it is raising in the current financing round. In the ideal scenario, that money is being used to pay for the existing team’s salary, for hiring new engineers or sales people, to execute a marketing strategy, to file patents, to pay for ongoing office rent and for other key expenses. If that is the case, then you can run the burn rate calculation we talked about above with the existing expense level ramping up to the higher expense level if they are growing staff. This will give you the expected runway that the new financing is buying.
dangerIn the worst case scenario, the company has been deferring salaries, and accruing significant credit card and other debt, including running up accounts payable with its suppliers. If half the funds raised are going to pay existing debts, for example, then you will be buying half the runway you thought you were, and the company will soon be out raising money again.
examplePete was asked if he wanted to invest in a company where he knew one of the founders and had been following the company’s progress for a while. It was a $750K fundraising round. When he dug into the documentation for the round, he was surprised to see that $450K was going to pay deferred salaries. Another $100K was to pay three months of component suppliers invoices. Pete politely passed on the round, and the company was out raising money again from its existing investors three months later.
Some amount of debt may be normal, and there are no hard and fast rules. Ideally, you don’t want it to exceed a month’s worth of expenses. If the company still has cash in the bank when you invest, then at least your investment will be used for moving the company forward.
founderMake sure you ask the founders whether they are taking a salary and whether that will change for them or any other employees when they raise this round. It is common that founders take no salaries very early on while they are bootstrapping, and then typically take a below-market salary after they raise an angel round. Founders typically have huge amounts of equity, and that will be their big reward if they are successful. That is how billionaires like Mark Zuckerberg and Jeff Bezos are made. Until they raise a significant amount of money, say $5–$10M, they should not be taking market rate salaries. Beware of any founder who expects you to pay for their $250K a year salary while they are taking angel investments. You want their equity to be their skin in the game. That said, not all founders have the same circumstances. A founder may be paying a mortgage and supporting a family, and it may be challenging for them to survive on a $75K salary. They may need $125K. That may be legitimate and should be a point of discussion and negotiation, and can be documented as part of the deal as appropriate.*
examplePete was approached with a very early-stage deal—essentially two guys with an idea for something cool, and a bit of paperwork. They had no validation of the idea and no traction. In reviewing the business plan, Pete noticed that they were each planning on taking salaries of $150K from day one. The proposed investment was a $500K round. Essentially they wanted to be paid $300K to figure out if this idea had any legs. They were not putting in any of their own money, so in this case, the investors were taking all the risk, and the entrepreneurs have little or no skin in the game. Where would their sense of urgency come from?
If a founder(s) has spent $50K or $100K to get the company off the ground, should they expect to be paid back with investors’ money? We would say “no.” That is the cost of their initial 100% equity ownership. When they are raising money and valuing the company at $1M, they have already made a hypothetical 10–20X return on their investment.
Don’t Fall For Vanity Metrics
dangerWhether listening to a pitch or conducting due diligence, beware of vanity metrics.
examplePete was doing due diligence on a consumer mobile app startup a few years ago that said in their angel pitch that they had achieved 30K downloads from the Apple App Store in their first week. That sounds impressive, but how many of those downloads turned into real engagement that could eventually be monetized? A few probing questions revealed that the founder knew one of the editors of the App Store and was able to get the app featured. It turns out that 30K downloads is pretty typical for a featured app, and that once that visibility was gone, the download rate fell precipitously. The entrepreneur was not lying, they were just touting a vanity metric. While downloads are necessary, they are not sufficient or directly indicative of potential profitability.
Vanity metrics are numbers that may sound exciting but don’t translate in any direct way to the health of the business.* In a B2B scenario, a vanity metric would be how many people came by the sales booth at the conference. The meaningful metric is how many qualified sales leads came from the conference.
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