A pro explains how a well-done financial statement can help turn a potential investor into your biggest backer
Raising money from outside investors is fundamentally an act of financial communication. Ultimately, success is a function of financial presentation skills. Here's how to develop both historical financial statements and projections that speak to the needs of equity investors.
Entrepreneurs must first work through each line of the income statement and present a credible picture of the company's future performance. Each line, of course, must be consistent in the context of all the others.
Estimating sales. Given all of the importance laid upon earnings, it's amazing how much attention is paid to revenue. After all, a company with $100 million in revenues and $101 million in expenses doesn't have an ounce of value. Still, revenue is the starting point from which everything flows, so it's got to be right.
Established companies have it all over upstarts because they have some historically proven algorithm to predict future sales. Even if they've never thought about it, it's there. For instance, "historically, each salesperson generated 15 sales per month"; or, "each 30-minute infomercial generated 7,000 inquiries and 400 sales."
If it's historical and well-documented, it's credible. However, where entrepreneurs go wrong in projected revenues is in suggesting a future performance that deviates significantly from the past record, a malaise that undermines the presentation. If your projected revenues are going to depart substantially from past experience, there needs to be a good reason why. Without a good reason, the projections aren't credible.
For example, Dermaceutical Labs Inc. (DLI) of Idaho Falls, Idaho, was selling a line of skin-care products through direct-response television commercials. Historically, the company's sales were 1.25 times its expenditures on media -- a lot, but within industry norms. The name of the game was media buying. The more commercials the company could run, the more sales it could make. However, DLI's projections made the assumption that the ratio going forward would be 1.50. Why? According to DLI founder and president Marvin Taylor, "Once the company was funded, we would develop a new series of infomercials with better production values that would feature a celebrity spokesperson. We were confident that with these improvements, our TV infomercials would pull much better." Fair enough. At least 85% of Taylor's assumed future performance was based on past experience.
Estimating sales for prerevenue stage companies. For companies that don't have revenues, the act of projecting future sales is far more speculative than for companies with a track record. Fred Beste, a venture capitalist with NEPA Venture Funds, says, "It's naive to simply start with baseline sales and apply a formula that increases them by 20% per year. It's probably even more naive to suggest that the market is a certain size and that the penetration will increase a certain number of percentage points each year. The fact is, there's nothing formulaic whatsoever about projecting future sales."
The most effective sales projections for pre-revenue stage companies, he suggests, rely on some original market research or trial sales conducted by the founders. By doing so, the sales projections moves out of the realm of fantasy and starts moving into the world of reality.
At Intelligent Wireless Systems of Prairie Village, Kansas (a company that had developed radio frequency [RF] transceiver modules for the automation and control industry), founder Ed Meltzer needed funds to complete development and roll out his first products. Meltzer had an unfair advantage. Since the product technology was licensed from another firm that was fairly well known, Intelligent Wireless received a lot of inquiries and even purchase orders for its products while they were in development. Even IBM called one day. Meltzer supplemented these inquiries with calls to buyers of RF products.
Some questions Meltzer asked included: What's your time frame for purchasing RF products? What's the application? Is your project funded? Is there a scheduled launch? Is your application mission critical? How many units would you buy in a best- or worst-case scenario?
When he added everything up, Meltzer had some 750,000 units he could sell in the first year. Incredibly, he based his first-year revenues in 1997 on selling approximately 2.5% of what his research suggested -- 18,000 units -- and throughout the five-year planning period never assumed he would hit more than 25% of what his research showed.
At the end of the day, Meltzer was not conservative enough, at least for 1997. Raising the required funds took longer than expected, so there was much less time in 1997 to hit even the conservative target.
Cost of goods sold. No one will invest in a company where not even the founder is sure what the cost will be to produce the product or service. To get over this hurdle, Meltzer simply took his product design to the product manufacturer he knew he would be using and got a bill of materials from them. He took their prices and added in a fudge factor of 25%.
Gross margin. In reality, the cost of goods sold is simply a means to the gross margin. Gross margin is defined as sales less cost of goods sold, and is usually expressed as a percentage. What must the gross margin say or not say?
First, the gross margin should not be too far out of kilter with the gross margins that are earned in the industry at large. For instance, the National Restaurant Association reports that the gross margins for full-menu, table-service establishments are about 36%.
If you're opening a restaurant, and your financial projections show a 25% gross margin, up goes the red flag. If your projections show a 45% gross margin, up it goes again. While the former deviation is a tough sell, the latter is possible to overcome -- but only with a plausible explanation. Breakthroughs in technology, manufacturing techniques or management styles can change the economics of doing business and create an exciting investment opportunity.
A gross margin on a projected income statement is utopia. In real life, there are strikes, stock-outs, equipment outages and absenteeism. To add credibility to projected gross margins, build in a fudge factor of 2%-3%.
Selling, general and administrative expenses. The easy part of this projection is the general and administrative costs. If ever there was a place in the projections to simply let costs increase each year by a factor, this is it. Supplies are not expensive. Calculating the costs of centralized operations, such as executive and administrative staff, is fairly straightforward.
Where companies go wrong is with the selling expenses, according to Peter Moore, a principal with Banking Dynamics of Portland, Maine, a corporate financial consulting firm. Moore says that entrepreneurs who suggest too many kinds of selling costs clue investors to the fact that they're uncertain how to sell their product or service.
Operating income, or the operating margin. This is the famous bottom line, defined as gross income less selling, general and administrative expenses.
Where operating margins exceed industry averages, have a tenable explanation of why. In the same way that technology, management style and manufacturing techniques can cause a break-through on the gross margins, so too can paradigm shifts have a salubrious effect on operating margins.
In general, if the operating margin as a percentage of sales is small, it's a turnoff for most investors. There's little room for error, and it's harder to create the kind of value that offers an exit for investors.
KEEP HISTORICAL FINANCIAL STATEMENTS
It may seem odd to say, but the first step toward making a good financial presentation is to actually have historical financial statements -- one for each year the business has been in existence, or for the most recent five years.
Owners and managers of start-up companies are often prone to think they don't need financial statements because there's not much to put on them. This isn't necessarily the case.
First, if founders invested a lump of cash to get the business started, which is an extremely strong selling point, financial statements irrefutably document their commitment. Second, for founders who are working without pay or at less pay than to which they may otherwise be entitled, financial statements give them a place to document the company's growing liability to them.
It's also worth pointing out that to raise money, it borders on necessity that historical financial statements be prepared by a certified public accountant (CPA).
Even the lowest level of scrutiny red by a CPA provides a high degree of comfort to investors. Simply having financial statements can't completely carry the day, however. They've got to say the right things.
