Robert Ochtel’s Blog

An Experienced Approach to Venture Funding

Attractive Financial Statements – The First Step to Getting the Attention of the Venture Capitalists

Many first time entrepreneurs have given expertise in a certain area, be it engineering, marketing, business development, operations, etc. When developing their start-up company’s business plan these same entrepreneurs generally leave the development of their financial statements to last. There are several reasons for this, the most compelling of which is they do not understand finance or how to generate the required financial pro forma statements for their start-up company. This can be a big issue for many start-up companies, and one that needs to be addressed appropriately to get the attention of the venture capitalists. This article discusses several general issues facing first time entrepreneurs regarding the generation of financial pro forma statements that are attractive to the venture capitalists.

Venture Capitalists Are “Glorified” Financial Managers

It has been my experience that many of today’s venture capitalists are the products of top tier business schools with no personal experience in being an entrepreneur or starting a company on their own. On the other hand, what they do know is how to analyze financial statements. So, this is what they focus on first when considering a new start-up investment opportunity. This financial statement focus is necessary, since these “glorified” financial managers need to first justify any start-up investment opportunity from pure financial objectives, as defined by the financial return requirements set by their investment fund. Therefore, up front, to determine their initial interest in a new investment opportunity, this is what venture capitalists focus on. If the opportunity does not fit their pre-defined investment criteria, they quickly move on the next potential investment opportunity. This is not an emotional decision; venture capitalists have a board of directors to report to and predetermined investment criteria that are defined in the bylaws of their investment fund, usually an LLC. To these same venture capitalists, it is a numbers game, if a particular start-up investment opportunity does not fit their defined criteria they move on. This is why venture capitalists are generally very short with entrepreneurs and do not see it as their role to provide advice to these same entrepreneurs. A simple “not interested” or “no” is sufficient to them. This often leaves the entrepreneur confused and perplexed.

Return On Investment – Necessary, But Not Sufficient

The return on investment for your start-up company is a necessary, but often not sufficient criterion for consideration by venture capitalists and other professional third party private equity investors. Remember the rule the general of thumb for the venture capital community is 5 to 10 times return on their initial invested monies in three to five years, respectively. This is a goal and not necessarily a reality.

As an entrepreneur if your financial pro forma statements are projecting $50M to $100M in revenue in your fifth year of operations, these numbers, along with those projections for years one through four are discounted substantially by the venture capitalists according to perceived risk. This can be market risk, margin risk, technology development risk, competitor risk, etc. The key point here is that venture capitalists then take your start-up company’s financial projections and run them in their own financial models. This is done for a multitude of scenarios to see if your company’s financial projections hold up to their investment criteria under “worst case” condition assumptions. Therefore, your start-up company’s return on investment projections is only a single data point in considering your start-up company as an investment opportunity. It is only through their own thorough financial analysis that the venture capitalist determines if your company is a worthy investment opportunity and will consider moving forward to the next level of discussions.

Industry Standard Financial Pro Forma Statements

One of the most important factors venture capitalists consider for new investment opportunities is whether a start-up company’s business model is reflected in the market. That is, does your start-up company have a proven business model that is represented by successful companies in your industry segment in the market today. Or is your company’s business model new and unproven in the market. This is an important factor for venture capitalists to understand when considering investing in any start-up company.

Today, almost every venture capitalist I have talked to claims they would have invested in Google. In reality, this 20-20 hindsight does not consider that fact that at the time, Google’s business model was unproven in the market, and as such there were no reference companies that the venture capitalists could refer to that would indicate that there was little risk in their business model and projected financial returns. Hence, I believe that many of these same “Monday morning quarterbacks”, are most likely not telling the truth when they claim that they would have invested in Google, as one of the original venture capital investors.

The key to developing acceptable financial pro forma statements for the investment community, is to develop industry standard pro forma projections, for your start-up, based on similar companies in your SIC code. This can be accomplished using information available on the internet or at your local public library, and is completely explained in my book “Business Planning, Business Plans and Venture Funding – A Complete Reference Guide for Start-up Companies.”

Understand Your Financial Statements and Their Assumptions

When presenting to venture capitalists, the CEO of your start-up company needs to be an expert in all aspects of your company, including its financial statements. It is not a good idea, as the CEO of your start-up, to defer the financial statement related questions to your CFO or another third party. As the CEO, you are the one where the “buck stops”, so venture capitalists expect you to be able answer any and all questions regarding your start-up company’s financial statements. Therefore, as an entrepreneur you need to study your company’s financial statements from an investor’s point of view, including being able to recite the underlying assumptions of your financial statements. If you cannot do this, you will not get far with the venture capitalists and your ultimate goal of securing funding.

If Necessary, Get Help

Developing complete financial pro forma statements for your start-up company is difficult and a daunting task for first time entrepreneurs. This is especially true if this same entrepreneur does not have a financial background. So, given this, the important thing to do is to seek help to generate the required financial projections. By securing a qualified financial consultant, you, as an entrepreneur and the CEO of your start-up company, will be much more confident in your company’s financial projections, and this will show when you present your company to your potential investors. Remember, as a minimum, you need to generate five year financial projections for your start-up company’s income statements, balance sheets and cash flow statements. Typically, for years one and two this is broken down by month and/or by quarter. For the out years, yearly financial statements are fine for venture capital investors.

As discussed, financial projections can make or break your start-up company with the venture capital community. Your start-up company’s financial projections are the first step to getting into the door of the investment community. Therefore, to be considered, your start-up company’s financial statements must provide an attractive return on investment to the venture capital community, while at the same time reflect generally acceptable industry standards. Also, it is important for you as a first time entrepreneur and the CEO of your company, to become the expert on your start-up company’s financial pro forma statements. This will set the appropriate tone and earn you respect with your potential investors.

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April 13, 2009 - Posted by | Finance, Venture Capital, venture finance

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