Monday, February 15, 2010

"Buying In" to the Numbers

As an Angel Investor looking at an early stage opportunities I often have roll up my sleeves and go into a Due Diligence exercise. Through this process, I warm up to the idea, I successfully poke at the technology and its patents, and I learn more about the leadership team and its ability to walk on water. If I remain excited about the concept and its market potential, I now turn to the financial section of the plan and wonder if I can Buy In to the numbers - "do they hang together in a believable sequence"?

There are essentially three sets of numbers that matter: Income Statement (Profit & Loss), Cash Flow (Operations, Investing, Financing) and the Balance Sheet (Assets, Liabilities, Equity). These three statements are interdependent and will require a financial professional to prepare and provide In Depth analysis. As an Investor, I know that the CEO can't be the expert on everything but I do expect them to be "Financially Literate" and be able to impress me with the highlights. Let's examine a couple of things that any CEO should be able to relate to on one of the key statements.

The Income Statement or Profit and Loss (P&L), summarizes the events that have occurred or are projected to occur in a given period (Month, Quarter, Year). The difference between Revenues and Expenses equates to the Net Profit of the organization.

  • Revenue - To me this deserves the most attention of our CEO as it reflects the effectiveness of the Go to Market Strategy. Are the products being sold as "one time" occurrence with an annual maintenance stream? Are they sold "as a service" with a monthly annuity payment? A new model that is also taking hold is the Freemium service. This is where the company provides its basic package for free and charges for any upgrades or feature enhancements. Freemium models lower the barriers for customers to sign up but have longer term conversion or upgrade issues. Many early stage companies will need to try a "couple of different" revenue models to hone in on what the market will truly support. The rules associated with Recognizing Revenue on the income statements are also important. Generally speaking, the revenue needs to be matched with the associated expenses in the period that it occurs. The Securities Exchange Commission (SEC) has indicated that majority of financial restatements are for Revenue Recognition treatment. Another key component of the revenue line is the Sales Pipeline which captures a 12 month view of how the customers are anticipated to purchase and install the companys' products. A good Pipeline names each customer prospect, their anticipated purchases and timing, revenue recognition assumptions and has a very disciplined probability weighing scheme.

  • Expenses - In early stage companies the cash is usually very constrained and founders are working for sweat equity rather than salary so some of the historically numbers and ratios may not be representative of the financial picture moving forward. Staffing plans with associated salary and bonus levels, Administration spending, R&D programs, Cost of Goods Sold and the effect of productivity increases all need to be articulated with a solid set of assumptions. There must be sufficient detail to understand the key levers of the cost structure.

  • The Plan, Year to Date Actuals and a Forecast - The Financial Plan should be built on a yearly basis and "locked in" for reporting purposes. Assumptions associated with all aspects of the plan should be documented with key variances flagged for any significant change. At the end of each monthly reporting period, the actuals should be compared to plan of record and a revised Forecast should be made for the future period. A great habit to get into would be to have a "Rolling 6" quarter view of the situation.

  • Scenario Planning - A series of What If scenarios should be created that outline a probable, worst case and home run set of plans. A simple summary sheet that outlines the assumption changes for each scenario would be a useful tool for any reader of the material. A potential investor will utilize these scenarios to understand the key risks to the plan.

  • Ratio Analysis - A number of Ratios can used to analyze revenues and expenses in both a Horizontal (% change over time) or a Vertical orientation (% of the total). Beyond the simple % calculations there are a number of other ratios that analyse the Profitability, Resource Utilization, Liquidity and Stability of the company. These ratios utilize inputs from all three of the Financial Statements. Anticipate that others will "do the math" on your numbers - be appropriately prepared to discuss both your Ratios and those of your competitors.

  • Net Income - Net Income is what remains after you have deducted all the expenses including Interest and Taxes from your Net Sales. The profitability of the company can be manipulated by moving the revenue or expenses into different periods from one another. Generally Accepted Accounting Principles (GAAP) mandate the matching of these items into the period in which they occur.

It is recognized that many of our early stage CEO's may not be financial professionals. It is however expected that they will be Financially Literate and be able to understand the key assumptions and guiding principles that form the basis of their financial model.

A CEO who is able to demonstrate a clear financial understanding of their business will have better Buy In from potential Investors. It's not acceptable to suggest that you aren't the "Numbers Guy" so you don't know!

1 comment:

  1. I agree the numbers are key, and the most important element of the company's valuation, but the income statement and cash flow analysis are a record of past performance. How well the strategy hangs together and the calibre of management andtheir ability to execute the strategy are better indicators of future performance: how big is the immediate market, who and how strong are the competitors, what are the trends and discontinuities that affect market size and growth opportunities/challenges and the key success factors; have the company leaders delivered on their prior commitments, are they up to the future challenges, etc.

    So in addition to a "quality of earnings" report from an audit firm, there should be a "strategy report" to evaluate future prospects for profitable growth and value creation.