When preparing to raise funds, whether at an Angel level or a more advanced level (Series A or some subsequent funding stage) startups and other early stage companies must have an understanding of their financial pro forma in order to be successful (financial pro forma are projections or other financial models of future results). Throughout my career, one of the most common mistakes I have observed has been misunderstanding the difference between financial pro forma and historic financial statements. The purpose of this article is to clarify some of the expectations Investors have regarding your projections.
Although both your historic results and your pro forma are important, particularly for early stage companies, Funders are most interested in your prospective results – your potential. Chances are you have had little actual results, and in many cases not much beyond development expenses, basic staff and a few sales. Remember, if you were a 100 year old soap company, Investors would not be interested in you, they want to know how you are going to become the next great company.
Preparing a financial pro forma is a different skill than an accountant preparing financial statements of past results. Said differently, “Finance” is different than “Accounting” and one of the mistakes that I have repeatedly observed among early stage companies is not appreciating that difference. Finance is about looking forward and Accounting is historical.
One example that I use to describe the difference between Finance and Accounting is as follows: an Accountant will spend time determining what month to “recognize” income for a $200 sale; but a Finance professional will focus on understanding how to grow $200 of sales into $20,000 then $200,000 then $2,000,000 in sales. I don’t think anyone will be surprised that Investors are more interested in the company growing to $2,000,000 in sales (and way beyond) than they are about whether you had $200 of income to show in this month’s, or next month’s financial statement.
Accounting becomes more important with maturity, scale and complexity. Early stage companies lack maturity, and its scale and complexity is based on expectations and not actual results. Therefore, Finance is more important to early stage companies and more important to Funders.
Profit and Loss Forecasts
When preparing financial statements for Investors, generally a depiction of the profit and loss is the most important and most scrutinized. The profit and loss statement should be forecast on a monthly basis for the initial or next twelve months and annually for years 2-3 or years 2-5. Investors will know, and expect that the forecast profit and loss for an early stage company is highly volatile and uncertain. Your early stage company does not have years and years of results to build a model for future results. Investors expect you to use your financial pro forma to support your vision, and demonstrate a thought out plan for growth and understanding of the metrics and key performance indicators that will drive growth.
One of the purposes of your pro forma is determine the important financial keys to your business model’s success. For some companies this is break-even, where monthly expenses meet revenue. Some businesses are focused on building revenue or other assets with an exit (sale or merger) in mind, and still other businesses plan to continue spend significant amounts of capital long term (think of Tesla or even Amazon) without a near term focus on profitability. Your pro forma is important to demonstrating to Investors how your strategy will play out.
Think about the profit and loss statement in two logical components: revenue and expense. With regards to revenue, they will want to understand your assumptions on your industry’s market. What are your assumptions about the pool of potential customers. Who are these customers? What is their behavior? How will you attract them, and do you have realistic expectations for the percentage of the market you can attract to your product or service?
Although these assumptions won’t actually show in your forecasted profit and loss, they are critical to your support for the actual projection. When it comes to revenue, Investors will be focused on your ability to generate a realistic projection based on assumptions around how you will get market share. One of the most common mistakes made by Entrepreneurs is failing to forecast realistic sales and marketing expense compared to revenue. Don’t fall into this trap, be realistic and understand that generating sales requires sales and marketing expense.
A few tips on expenses beyond sales and marketing. Investors usually will not dig into each line item, for example, they probably won’t scrutinize reasonable assumptions for your office and occupancy costs, but they will look at expense categories that are critical for your business. Many of the early stage companies that I have been involved with were in regulated industries such as financial services. Investors expected to see, and a red flag would have been tipped if forecasts failed to project legal expenses for regulatory issues. Similarly, a technology startup would fail to convince Investors without corresponding technology spend relative to sales and growth.
Other Statements
The other financial statements such as Balance Sheet and Statement of Cash Flow can be forecast as well, and their importance to Investors will typically increase with the maturity of the business. There is little difference between the Statement of Cash Flow and Profit and Loss for very early stage companies. Likewise, early stage companies lack the maturity to build significant balance sheets. A financial professional will assist an Entrepreneur in considering issues about what a future balance sheet will look like, but most Investors are much more focused on revenue and expense expectations relative to your market than they are focused on balance sheet.
Summary
Don’t confuse accounting with finance. Your financial projections are critical to convincing Investors and you need to have experience preparing these statements or use professionals who are experienced in preparing projections. That professional may or may not be your accountant.
Your projections build upon the market you are targeting and strategies you will use to gain customers and market share. Without a sound and realistic understanding of your market your potential Investors won’t believe your projections about how much revenue you will generate, and how much it will cost you to generate that revenue.
Finally, all projections of financial results should contain some disclaimer that such statements are “forward looking” and should not be relied upon by the user for investment purposes without advice from their own financial advisors. A complete discussion of disclaimers is beyond the scope of this post, but it is an easy and important step that should not be left out.
About the Author, Christopher Calvert
Chris’s experience includes a variety of senior management and founder level experiences with startup, early stage companies and business lines in a financial and legal capacity. Chris also has significant transactional experience advising and representing companies of all sizes executing corporate transactions such as angel and venture capital funding, mergers and acquisitions, dispositions, and borrowing. Chris specializes in the development of pro forma, financial models of all kinds (acquisition, new business development), budgeting, forecasting and strategic consulting. His experience includes many industries and organizations ranging in size from early stage to upper middle market companies. Contact Chris at christopher.calvert@ymail.com for more information.