Companies that are seeking private equity from angel investors or angel groups should understand that they will need to withstand some degree of financial due diligence. Depending on the sophistication of the investors, the degree of rigour applied can vary a great deal. Regardless, it is best to clean up your financial information and assumptions to get rid of the rough edges before you present them to potential arm’s length investors.
At a recent meeting of Keiretsu in Vancouver, BC – I had a chance to review financial information provided by 6 companies presenting information to the group. Each of these had significant rough edges in their financial presentations – most of which can be categorized in one of 3 ways:
- EXCESSIVELY HIGH VALUATIONS
- FINANCIALS THAT DON’T CONFORM TO GAAP
- UNREALISTIC REVENUE PROJECTIONS
In fact most exhibited at least 2 key sticking points in their presentations, any one of which would give prospective investors pause during due diligence.
1. EXCESSIVE VALUATIONS
In their first year of operations, one company expected to spend $400,000 in development costs with no revenue. They are looking at a pre-money valuation of $3.5 million before the end of the year.
In their second year of operations the company experienced a fourfold decrease in revenue and a $1 million loss – compared to a break even year in their first year. They explain their $7 million pre-money valuation based upon a “pivot” in the second year.
The company experienced a $250K loss in the first 3 quarters of the current year. They are now projecting a $250K profit for the entire year and based upon that they are looking for a pre-money valuation $12 million. This is down from $15 million post-money valuation from an earlier round.
2. FINANCIALS THAT DON’T CONFORM TO GAAP
Company showing a negative inventory of $65,000. This presumably arose when the bookkeeper made an entry to correct cost of sales. Effectively it is impossible to have negative inventory. That probably represents revenue, a liability, or simply a posting error. The thing is, when you’re presenting to investors, get your CPA to ensure that they make sense before you distribute them.
Company with half of their $800K of assets represented by other assets – which remains identical from one year to the next. Given the nature of the business, the assets were probably development costs. Since the company is in a loss position – and has never been profitable – they would not meet the standard for capitalization under generally accepted accounting principles(“GAAP”). Regardless of what it was the CEO couldn’t explain what half his assets were.
3. UNSUBSTANTIATED EXPONENTIAL GROWTH
Since angel investors are looking for exponential growth, it is pretty much expected that investee companies will project exponential growth. However it strains credibility if you project 200 times revenue growth in a single year. Most of the rest of the companies in my sample used 10 times growth at least once in their projections – which is almost certainly way too optimistic.
While most presentations by startups feature some or all of these 3 key financial sticking points, angels themselves have developed interesting “back-of-the-napkin” approaches to deal with some of these problems:
MILLION DOLLAR DOG FOOD RULE
“No deal is worth more than a million dollars unless some dogs are paying to eat the dog food!” (i.e. unless there are customers)
DOUBLE HAIRCUT METHOD
This method assumes that most founders will overstate revenue in year 5 by at least 75%. That means halving the revenue projection twice in year 5. It also assumes the same level of capital as required in the original forecast.
TWICE AND A HALF RULE
Assumes that twice the amount of capital will be required to achieve half of projected revenue in year 5.