If you have historical financial statements, your would-be venture capital investor will take high interest in them. VCs typically look at financial statements differently than other investors, and certainly differently than a lender would.
This three part series will look at the primary elements: the income statement, statement of cashflows and the balance sheet. This is Part III, the balance sheet. (If your company is very early or seed stage, read on regardless for insights on how to construct your financial statements once expansion materializes.)
Following scrutiny of the income statement (see this section here), most investors will look over the balance sheet. Unlike a banker, an equity investor is much less concerned with the presence of assets to liquidate if there are problems. Whatever hard assets there may be, are likely pledged to somebody else anyway.
Most investors will zero in on the intangible assets. Whereas these don’t mean boo to a lender, they speak volumes to an equity investor, especially for a technology-oriented company. For instance, if a company is capitalizing research and development (that is, treating expenditures for R&D as if they bought an asset), that’s good because it shows a significant commitment to product development and improvement, which hopefully will fuel future sales.
By the same token if a company is too aggressive in their allocation of R&D expenditures to asset rather than expense accounts, it could be a negative. A more conservative look at intangible assets might cause a reclassification of R&D expenditures as expenses, and in the process, deliver a big hit to earnings, and a hit to earnings could cause the next round of financing to be done at a lower valuation, which reverberates all the way back to the VC’s limited partners.
Next, for companies that sell physical products, most investors will look at the inventory to see if it’s in or out of kilter with revenues. If the inventory account is high relative to the revenues, or has been creeping up over time, it can give pause. Maybe the company is gearing up for a big sale or maybe the company has poor management controls and is not responding to changes in it sales cycle.
Regarding accounts receivable, if there are any, many investors will take an interest in the revenue recognition policies — that is when during the sales cycle the firm actually books its revenues. In general they’re trying to see just how firm the revenues are the company is reporting. Growing businesses sometimes push sales out the door and book them right away, a policy that can be crippling with complex products or services that may take months to deliver to the satisfaction of the customer. Technology driven receivables can be particularly volatile because the product or service is new, and customers may not fully appreciate the value they are receiving, or thought they were receiving.
Going over to the liabilities, accounts payable can cause problems. Sometimes a $1 million investment will get whittled down to half than amount after the creditors stake their claim. It’s not unheard of for investors to get on the phone to the creditors to see if they will hang in there a little longer.
Moving down the liabilities, if there’s any term loans, the investor’s comfort with them will vary directly with the length of the term. If its 2 years, that could be a problem. If it’s seven, that’s much better.
Further down in the liabilities section, there are often accrued salaries or ‘Notes Due Founders.’ These can spell trouble for the entrepreneur who is not flexible. Bankers simply subordinate these to their own debts and forget about them. But equity investors get a little prickly on this topic. Basically, they don’t want to pay off founder’s loans. What founders and owners call loans, VCs typically call sweat equity.
Next, the investor will look at the equity section of the balance sheet. First, they want to see if it’s negative or positive. Remember, at the end of each year, the net income or net loss gets posted to the equity section of the balance sheet. So if the company has been stringing together a series of losses, the equity will be pretty thin. If the equity account is negative, the company is technically insolvent. At the very least, it’s running on fumes.
Finally, the investor will take a good long look at the notes to the financial statements. In fact, notes are so important, that some investors read them first. Notes to financial statements are one more reason that CPA-prepared financial statements are essential. Internally generated financial statements rarely have them, which has the net effect handicapping the investor, who may simply walk until notes become available.