The potential of your business is important to any venture capitalist. All VC companies make big bets in hopes of an abnormal return.
However, even if a VC is interested in the future performance of a company, they’ll certainly want to know about your past performance. It’s all about due diligence. The past is an indication of future success, and if you’ve had a rocky past, it’ll be harder to convince a venture capitalist that you’ll have an idyllic future.
VC firms will pour over your financial statements in an attempt to better understand company performance and the leadership of its senior staff. For this reason, it’s important to understand what a venture capitalist looks at when analyzing a company’s financial performance.
Below is a list of items on your financials statements that a VC firm will use to identify past - and potential future - company performance.
The first thing that a VC firm looks at is the margins on your income statement. The three big one’s that they’ll analyze are your gross, operating, and net profit margins. What they’re looking for is to verify that your margins are in line with industry averages.
It’s important when you’re speaking with VC firms that you know where these numbers stack up against industry norms and against your competitors.
Strong businesses are ones that have revenue that’s recurring in nature. VCs will therefore seek to understand whether or not your revenue is recurring. Further, they’ll want to see a segmentation of your revenues based on product lines, if any. Finally, venture capital firms will look at the trend of your overall revenue. Is it growing, stagnant, or shrinking? If it’s stagnant or shrinking, make sure you know the reasons why and can speak to those reasons.
3. OPERATING LEVERAGE
This is a measurement of the degree to which a company incurs fixed and variable operating costs. The idea here is that a business with a high gross margin and low operating costs has a lot of leverage. Conversely, companies with high operating costs in relation to their gross margins run the risk of insolvency and forecasting risk, which is the risk that a small miscalculation in future sales can have disastrous effects on cash flow.
VCs want to invest in companies with high amounts of operating leverage. This is because companies with high operating leverages can increase revenues with only incremental increases to operating costs.
4. INTANGIBLE ASSETS
Assets are found on the balance sheet. “Intangible assets” are considered the assets that aren’t physical in nature. Such things as goodwill, for example, are intangible assets.
For a VC firm, intangible assets are important because it gives clues as to how a company is preparing its financial statements. For example, most tech startups incur a large amount of research and development (R&D) expenses. It’s possible, however, to capitalize these expenses, which places them on the balance sheet as an asset that declines over time, as if it was depreciated.
Capitalized R&D expenses can actually be a good thing for investors. It shows that the company is dedicated to fueling business growth through consistent iterations. However, too much R&D expenses in the form of intangible assets might raise a red flag. This is because if and when future R&D expenses are classified as an expense rather than an intangible asset, it’ll eat into a company’s profitability.
Make sure that you’re not being too aggressive with your classification of intangible assets, such as R&D expenses.
Technology companies need not worry about inventory. If your company is more traditional, however, you’ll have your inventory on your books and VCs will want to better understand the numbers. If a company’s inventory count is high relative to its revenues, or if it’s been increasing over time, it could be a sign that the business has too much of its capital tied up in an illiquid asset.
6. ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE
The next thing a venture capital firm will want to understand is a company’s accounts receivables (A/R) and accounts payables (A/P). Accounts receivable is the money owed to your business from customers. Accounts payable is the money you owe vendors and third party companies for their products and services.
A venture capital firm looks at a company’s A/R to see how it recognizes its revenue. If your A/R account is large, it could mean that you’re recognizing your revenue too aggressively or that you’re not collecting money owed on time. However, growing companies naturally have A/R and it’s not necessarily a bad sign.
A/P is interesting to investors because it represents money that a company owes. So, if a VC firm wants to invest, but it sees a high amount of A/P on your books, they might assume that most of their investment will go to paying off creditors.
This represents both “sweat equity” in the form of deferred salaries or notes due to founders, as well as the equity that represents the net income or loss earned by the company.
VCs aren’t wild about deferred salaries or notes due to founders because they often view this as the sweat equity required to grow a company to investment level. Positive equity is great for investors because it represents a profitable company, while a low or negative equity means a company is insolvent or nearly so.
8. CASH FLOWS
Finally, investors will want to look at the nature of your cash flows. These numbers aren’t the most important since companies that raise money are usually in need of cash, but it still shows how the business owners manage their cash.
Operating cash flow and working capital are necessary for any growing business. Make sure that you have stable working capital to show your potential investors.