CHAPTER FOUR
Understanding Your Funding Needs
One of the most difficult aspects of any seed/startup company is understanding your financial needs. Optimism is a characteristic of many entrepreneurs, along with dogmatic belief in their idea and company. Investors look for these qualities in an entrepreneur, but they also want a dose of reality. So how do you realistically determine your financial needs? How much do you need to get to profitability? What factors impact your finances, anticipated or unpredicted? The scenarios are nearly limitless and no investor expects you to consider every possibility. What an investor does expect is evidence of well-considered, realistic financial projections and a realistic timetable for growing a successful company, a timetable that reflects an understanding of the market in which the company operates.
BUILDING YOUR FINANCIAL STATEMENTS
Entrepreneurs need to ask themselves a few questions when starting to build their financial models:
• What financial documents do you need?
• How many years of projections should you provide?
• How much detail is necessary?
• What are the most important factors or variables for investors?
Just as you need counsel to help with legal aspects of your business, you should retain a qualified financial strategist experienced in early-stage companies to help you answer these questions. The earlier you retain capable professionals, the better prepared you will be for your angel investors. You do have to balance cost with timing. But remember, knowledgeable professional advisers are value-added experts in their fields, as well as resources for investors, partners, and team members.
Building Your Financial Future
Angel investors want to know how you are going to make money, when you will turn profitable, and when they can expect to receive a return on their investment. You need to address these important financial milestones in your executive summary, business plan, and presentation in differing degrees of complexity, and your financial documents need to support your assertions and forecasts. Flowery adjectives are unimpressive and can even turn off an investor, and you will never get funding if your numbers don’t back up your assertions. Therefore, building a comprehensive financial model is essential. You need to understand all aspects of your company, including what goes into generating revenues, how much it costs to build your products, overhead, and when you will probably reach profitability. While most investors realize that anything past a couple of years has enormous unknowns, they will want to know you are thinking for the long term, so you need financial projections for three and preferably five years. Because of the inherent uncertainties in future projections, investors often ask entrepreneurs to develop contingency plans in anticipation that milestones take longer to accomplish, market adoption is slow, economic slowdowns occur, and so on. These contingency plans explain how the company can survive (though not necessarily grow) until limiting factors disappear.
Pro-forma (or future projected) financial documents include numerous tables, inputs, calculations, and variables. During due diligence, many angel investors will want to see all backup documentation—staffing schedules including compensation, product distribution schedules, a detailed cost of goods, and the like. You will need to present at least these three “master” or essential documents:
An income statement (also referred to as a profit/loss statement) tracks revenues and expenses. The more comprehensive and complete the expense assumptions and the revenue projections, the more realistic the income statement. Information such as compensation, including fringe benefits, as well as Selling, General, and Administrative Expenses (SG&A), operations, and so on, all go into building an income statement.
A balance sheet that provides information on assets, liabilities, and equity or shareholder ownership, and is computed from estimates based on your current and expected situation. Assets will be anything of value to the company, roughly divided into current assets (cash and accounts receivable) and fixed assets (equipment, fixtures, furniture, and the like). On the other side, you’ll have current liabilities (accounts payable and short-term notes) and long-term liabilities (typically financial obligations of greater than one year). Shareholder equity is valued on the balance sheet and will show retained earnings and net income or loss (with loss being the case for almost all start-up companies). Together liabilities and shareholder equity represent legal claims on the company’s assets. Thus, assets must equal the sum of liabilities and shareholder equity.
Cash flow statements track actual cash receipts and cash disbursements, and are often derived from the balance sheet and income statement. These statements will show your cash position at a point in time, commonly on a monthly basis, giving your investors an understanding of when you anticipate to turn cash flow positive, and will also lay out your future financial needs.
Financial documents must have a comprehensive list of assumptions that support and explain your numbers. Assumptions explain how you calculated your financial needs, timing for infusion of money, revenue projections, market growth, and the like. The following box gives a partial list of assumptions used in building financial statements. While not all the listed assumptions may apply to your company, consult with your financial planner before you rule out any factor.
Your documents will have information that depicts your company’s current reality in addition to the projected financial values. Actual numbers and projections based on the numbers behind the assumptions drive the creation of your three primary financial documents.
FINANCIAL ASSUMPTIONS
• Start-up costs
• Research and development activities and timing
• Capital equipment purchases, including depreciation and amortization expense
• Commercial start date (first sale or shipment) for each product
• Market expansion timing, including increasing unit sales over time along with market expansion costs
• Sales forecasts
• Costs associated with all operations
• Cost of goods
• Financing needs and timing
• Debt issuances and repayment
• Staffing and average salaries by position, along with increases over time
• Necessary license and royalty payments
• Figures in home country currency and exchange rates used if applicable
• Patent prosecution and maintenance expenses, domestic and foreign
• Raw materials costs, inventory, and work in process, including inventory purchase and utilization rate
• Accounts payable and accounts receivable forecasts, including payment periods
• Variable costs such as expected inflation rate and commodities trends
• Analysis period
• Industry- or product-specific factors or variables
• Taxes
Building Financial Documents: The Essential Information
Your income statement, balance sheet, and cash flow statement will provide your prospective angel investors with three important types of information that tie back to their primary interest (their eventual exit): revenue, margin, and profitability. First, can you generate impressive, highly scalable revenues in your initial market and eventually additional markets or industry areas? Second, do you have projections for healthy margins that are at least as good as industry average, if not better? Third, when do you become profitable and how do you grow the bottom line to a point of maximum value and ultimate investment liquidity? Fourth, will your business generate more cash from its operations than it will spend?
The best way to understand what information goes into the income statement, balance sheet, and cash flow statement is to look at an example—once again using Great Starts, Inc., a hypothetical software and high-tech scanner start-up company. The documents in
Exhibits 4.1 through 4.4 show numbers down to the dollar for the first year, after which no one can anticipate the future that accurately. Therefore, as shown in the following tables, you should round off numbers such as revenue past the first year of projected financials.
Exhibit 4.1 shows all revenue and all operating costs, providing the company’s net income or loss. This kind of statement is also referred to as the income or profit-and-loss statement, and it is used to track revenues and expenses so that you can determine the operating performance of your business over a period of time.
Exhibit 4.2 contains information on assets, liabilities, and shareholders’ equity. As noted earlier, assets are divided into current and fixed, and liabilities are divided into current (or short-term) and long-term obligations. An asset is anything the business owns that has monetary value. Liabilities are the claims of creditors against the assets of the business, and equity is the shareholders’ residual ownership of the assets. In addition, assets must always equal liabilities plus shareholders’ equity. Therefore, the balance sheet is a snapshot of a business’s financial condition at a specific moment.
Exhibit 4.3 provides information on cash flow in and out for a specific period of time. This information is particularly important for young companies with limited resources. This statement serves as an early warning system for impending cash flow problems. The statement shows a beginning cash balance, which includes the starting available cash. Projected cash sources, such as accounts receivable and financings, are calculated for the next period, as well as cash demands for the same period. Therefore, even if you have a positive beginning cash balance, you can end with a negative cash balance if the cash demands exceed the period’s cash sources plus the beginning cash balance.
The following list gives you a better understanding of the complexity of information built into just the expense side of the financial documents. Recognizing expenses is important; unexpected revenue is rarely a problem, whereas unexpected expenses can often be disastrous.
Compensation per Employee
• Salary
• Performance Increase
• Medical and Dental
• Social Security, Medicare, and Other Taxes
Balance Sheet Information
• Capital acquisitions:
Computer and Network Equipment
Phone Equipment
Leased Equipment
Leasehold Improvement
Office Furniture and Fixtures
Lab Furniture and Fixtures
Trade Show Displays
Lab Equipment
Manufacturing Equipment
• Accounts Payable Outstanding—for eligible expenses
• Credit Card—Outstanding
• Returns and Allowances
• Inventory
• Debt
• Bad Debt Expense
Employee-Related Costs
• Telecom Service—Data per month
• Office Supplies
• Office Space per person
Fixed Asset Financing—Annual Rate
Accounts Receivable Collections, Including Timing
Marketing
• Advertising
• Collateral
• Trade Shows
• Rep Commissions
• Distributor Aids and Supplies
• Market Research
• Sales Training Video
Professional Services
• Accounting, Tax, and Bookkeeping
• Legal
• Consulting
Office Expenses
• Lease and Leasehold Improvements
• Telephone and Internet
• Postage and Shipping
• Office Supplies
• Computer Expense
• Office Operation Equipment
• Rent
Travel and Entertainment
• Trips per Month per Traveler
• Travelers per Month
• Nights per Trip
• Entertainment
• Travel Meals
• Business Meals
• Air Fare
• Lodging
• Car Rental
• Local Mileage, Parking, and Taxi
Employee Related
• Social and Employee Meals
• Dues and Subscriptions
• Seminars, Classes, Presentations, Fees
• Relocation
Federal, State and Local Taxes
• Income Tax
• Business and Occupation Tax
• Sales and Use Tax
Insurance, including general comprehensive, property, professional liability, and health
Bank and Credit Card Charges
Research and Development
Exhibit 4.4 shows the essential information for your business plan financials. It gives an excellent summary of key information your prospective investors want to understand in their initial review of your company. Revenues are shown along with product volume to support the revenue projections. With this single table, an investor can analyze the reasonableness of key assumptions on sales and pricing, as well as staff necessary to support these sales numbers and corresponding services. Expenses against revenues can also be evaluated. Finally, cash flow gives the investor an understanding of your ongoing capitalization needs.
WHAT FINANCIALS TELL AN INVESTOR
If your financial projections show that you will need considerable funds to become cash flow positive, reach profitability, and become a self-sustaining business, you need to map out how you will raise these funds. For example, assume you have an innovative and noninvasive procedure for detecting early-stage lung cancer. You know several phases of clinical studies will be needed to reach a commercial product. After working with your financial strategic adviser, you determine it will take at least $45,000,000 to fully commercialize the procedure. With such a large amount of money needed to fund the start-up, angel financing alone will not come close to meeting your funding needs. As discussed earlier, going out and trying to raise all the funds you need in one round is unrealistic and seldom a good idea. You will need venture capital financing—but because you are so early, venture capital providers may not be willing to take the risk on you. Most important, raising $45,000,000 on a highly promising but untested invention will not yield the kind of valuation you need to keep any realistic percentage of ownership. You will not be able to raise such funds unless you have a long track record of successfully taking inventions to commercialization, so investors have an unusually strong belief in your capability.
The solution to this problem is to raise your capital in phases. You must develop a road map of milestone achievements that will look impressive to potential investors. By having milestones for each funding round, you build value for your company through your accomplishments. Your milestones will lead to further financing, which will fund continued development. Taking this approach also allows you to retain a greater percentage of your company.
The dot-com bubble approach of throwing gobs of money at an idea has greatly diminished or entirely disappeared in many parts of the country, which is a good thing. Being able to live lean and create $50 of value from $5 is the sign of a great entrepreneur. Investors are looking for wise use of funds, so you must be innovative and intelligent in your spending. Do not use invested funds to pay yourself a big salary, no matter what you could make elsewhere—investors want funds to go to growing the company. Do not use invested funds for costly office space and furniture; sophisticated investors will find space in an older commercial building—even one large room and a restroom down a flight of stairs—more impressive. Stretch the first dollar invested; stretch the last. Your brass ring is the value of your stock and the value you continue to build in your company.
As explained in Chapter Two, investments are often made in traunches, meaning that investors require the company to achieve certain milestones to receive a portion of the agreed-to funding. In theory, this approach reduces the chances of an investor throwing good money after bad. If you cannot achieve the goals and milestones set out in your financials and elsewhere in your business plan, investors will decide you have an unrealistic or losing business proposition. Not surprisingly, many of these milestones are tied to financial projections, including commercialization, sales, additional funding, licensing, additional product lines, and the like. Traunching requires the accomplishment of a specific event or events by a certain date.
To illustrate this point, suppose the fictitious company Great Starts, Inc., receives investor commitments of $750,000. The investors were a bit skeptical about sales assumptions Great Starts’ founder, Jane Merrill, presented; they asked for an adjustment, but she was emphatic about her numbers. She has confidence in making the numbers because of the advanced stage of discussions with several potential customers; she also knows that adjustment of sales numbers can affect the valuation. The parties agree to traunch investing, with $250,000 at the time of signing financing documents, an additional $250,000 upon two potential customers submitting purchase orders, and the remaining $250,000 upon shipment of goods. No timing is tied to these events in this example, but investors could very well insist on specific dates if the market has potential competitors and being the first to market is one of the founder’s stated competitive advantages.
When it comes to providing entrepreneurs with adequate incentive to accomplish milestone events, some investors will require an increase in their ownership if the company fails to accomplish certain milestones, particularly follow-on funding, in a timely fashion. For instance, an angel investor will enter into a convertible debenture or note with you, with automatic conversion upon completion of a subsequent round of financing of $3,000,000. If you accomplish this milestone within three months of signing the convertible debenture, the angel receives only five thousand warrants, exercisable at $0.50. However, if you fail to close on the financing in three months, the angel receives an additional five thousand warrants for each month of delay until the subsequent financing is secured. You can imagine the potential variables, from increasing discounts on conversion to additional shares to even board seats or control of the company. Some requirements can have extreme consequences; these should be critically assessed because investors need to have an inherent level of faith in you. Extreme or severe nonperformance consequences would suggest the opposite. In addition, such terms can have a chilling effect on securing subsequent funding, and you may not want such an investor as part of your company. Be careful when balancing your need of funding against the burdens such funding carries.
REGIONAL INVESTING TRENDS AND HABITS
Not all countries, states, or cities have the same appetite for high-risk investing. Entrepreneurism, investor sophistication, availability of follow-on financing, and acceptance of failure are all cultural variables between nations or regions. In the United States, the two coasts (more specifically, the mid-Atlantic and New England in the East and Silicon Valley, San Diego, and Seattle in the West) have been actively involved in early-stage angel financing for more than a decade. The Midwest has often been referred to as “the fly-over zone,” with some pockets of relatively exceptional activity such as Chicago. Recent trends in angel group development show a clear surge of interest in angel investing in the Southeast, Midwest, and Southwest. Outside the United States, Canada is experiencing an increase in angel group formation, but a dearth of early-stage financing remains in different provinces as a result of skyrocketing gas prices (making Albertan oil sands a great investment opportunity), though nothing is ever quite that simple. Parts of Europe struggle with angel financing partly related to cultural and socioeconomic factors in social democracies and the negative perception associated with failure. Other countries are simply not entrepreneurial by nature, again often reflecting social norms.
The question of which comes first, entrepreneurism or early-stage investment interest, seems a bit chicken-and-egg, with complex factors that often defy definition or measurement. What is clear is that most angel investors are prior entrepreneurs interested in building local economic vitality. It’s also clear that it takes a few home runs with high public profiles to get investment engines going; and it takes time to build communities like Silicon Valley. If you are in a region with little entrepreneurial activity, you are not likely to find much appetite for early-stage investing in your local market. Therefore, you may need to venture outside your region to find money. Bottom line: being fundable does not have to do solely with the greatness of you, your team, and your idea. Fundability involves complex factors of a greater social and economic nature, so you must understand your financial market as well as your product market.
SOURCES OF FINANCING
To prepare for angel encounters, you must first understand the numerous potential sources of financing that may be available, and the period in your company’s maturation when these sources are likely to take an interest.
Figure 4.1 gives a rough progression of which financing sources become available in different business phases. You need to understand that product development is seldom linear, and not all funding sources are available to all companies. The oval highlights the development stage at which angels typically invest compared to other financing sources.
Figure 4.1 puts some of the financing sources into context from the perspective of company maturation and financing stage, with many other sources of financing potentially available to entrepreneurs. These alternative sources of financing may be more appropriate for certain types of businesses, as not all companies are eligible for angel financing. Later, I will discuss what angel investors are typically looking for in companies, but for purposes of the present discussion, it’s enough to understand that angels are looking for many of the same attributes as venture capitalists and other third-party investors: a significant return on their investment, leading-edge technology, high growth potential, experienced management, and a clear exit strategy. Therefore, keep your reality hat on when seeking financing and remember that even if your business may not be appropriate for angel financing, you may still be able to develop a solid, profitable venture.
With these thoughts in mind, take a look at the various sources of financing an entrepreneur may want to consider:
Founder: Self-funding—savings, personal loans, credit cards, second mortgage: Most investors today require that the founder have skin in the game. In other words, the entrepreneur has to invest private funds, not just time, to create an attractive company. Some entrepreneurs are fortunate enough to have adequate savings to quit their day jobs and focus full time on making their ideas turn into reality. Most founders must use credit cards, second mortgages, and personal loans to get started. Failure to put yourself and your finances at risk can be interpreted as lack of conviction and unwillingness to make personal sacrifices, which translates for an investor to a lack of passion and determination to succeed.
Bootstrap: Some businesses have a modest amount of cash flow from the very beginning and can be grown through their own activities. Bootstrapping your business usually necessitates at least some initial period of continuing your day job while working on your entrepreneurial venture in the evenings and on weekends. This approach can be effective particularly for entrepreneurs uncomfortable with the idea of taking on debt or giving up equity.
Friends and family: For many entrepreneurs, friends and family members may have the ability to provide some of the initial capital the company needs. The amount that friends and family invest is typically modest and represents the very first funds needed to finish the business plan, create a prototype, or conduct validating research. Friends and family are often referred to as providing “love money” because their investments are made out of affection for you as an individual without the heavy analysis all arm’s-length investors insist on. Friends and family typically receive common stock for their investment, or may structure their investment as a debt instrument or promissory note depending on respective comfort levels. Do be cautious as to the number of investors you have in this category. Professional investors can be wary of friends and family because people in those groups are typically unsophisticated and lack understanding of the complexities and often harsh realities of company growth and change. Some professional investors will not invest in companies with more than a few investors in the friends and family round to avoid the hassle they usually entail. Most investors will take a dim view of your Aunt Sally calling every couple of days to ask about her retirement money. They fear you may make possibly inappropriate business decisions based on protecting your friends’ and family’s investments.
Equipment leasing: You can often leverage your own cash or that of your investors through leasing operational equipment. As an entrepreneur, you must stretch each dollar.
Bartering: Gone are the boom days when entrepreneurs received $10 or $20 million for an idea. Investors now expect entrepreneurs to live lean and make every dollar work like two. One mechanism is to barter or trade services with other entrepreneurs or businesspeople. While certainly not a primary source of funding, trading services or expertise can help stretch those precious dollars. You should be careful in bartering or trading services that ownership of any resulting product is clearly with your company. Therefore, be sure to either secure ownership through a contractual arrangement or avoid bartering for any services related to your products or company assets.
Angels: Obviously—being the focus of this book—angels will not be discussed at length here, but can be summarized as individuals with disposable wealth, almost always “accredited investors” as defined under Regulation D of the Securities Act of 1933, who typically participate at some level in decisions related to investment of their own wealth. Angels themselves put a bit of a twist on this definition—see “Angels Define Angels.”
Government grants and loans: The government has a vast array of grant and loan programs for small businesses, research, targeted industries, minority interests, and so on and on. Publications several inches thick are dedicated to information on these programs. Therefore, this discussion is highly abbreviated and provides only nominal information on a few of the larger and more visible programs:
ANGELS DEFINE ANGELS
David Grahame of LINC in Scotland defines an angel as “A private individual investing their own money into companies in which they can make a difference—an active and direct investment rather than passive. Angels have the ability to make a real contribution to the growth of a company.”
Mitch Goldsmith, a serial angel investor, gives a similar definition from a different perspective: “Angels are experienced in the pitfalls of building and growing a company. All businesses have commonalities regardless of industry focus. Angels who have been there and done that can provide unique experiential information to young entrepreneurs.”
Knox Massey with Atlanta Technology Angels puts it simply: “Someone who writes a check from their own checkbook. Angel investing is an individual choice; no angel has to make an investment.”
Small Business Innovation Research (SBIR) is a highly competitive program that encourages small businesses to explore their technology potential for commercialization. Since enacted in 1982, the SBIR program has helped thousands of small businesses through federal research and development awards. To qualify for an SBIR grant, you must meet certain criteria including being an American-owned or operated for-profit company with the principal researcher employed in the United States and fewer than five hundred employees. Each year ten different federal departments and agencies award funds. SBIR grants are awarded in phases, with phase I grants providing up to $100,000 for exploration of technical merit or feasibility of an idea or technology. Phase II is for up to $750,000 to evaluate commercial potential.
Another government grant program is the Small Business Technology Transfer program (STTR; the “R” is the second letter of transfer ). STTR provides fund opportunities in federal innovation and development to expand public-private partnerships through joint ventures, among other means. Grants are awarded to small businesses and nonprofit research institutions. The same eligibility requirements apply to STTR grants as SBIR grants. Five federal departments and agencies issue STTR grants, with a similar phased approach. Many other government grants are available through numerous programs.
With regard to government loans, the Small Business Administration (SBA) offers numerous loan programs. It is important to note, however, that the SBA is primarily a guarantor of loans made by private and other institutions. The SBA’s loan program helps qualified small businesses obtain financing when they might not be eligible for business loans through normal lending channels. It is also the agency’s most flexible business loan program, since financing under this program can be guaranteed for a variety of general business purposes.
Economic development programs: Loans, tax incentives, tax credits, and other provisions are available for specific industries, certain minority ownerships, or in certain geographic areas. Federal, state, regional, and local government entities have a variety of economic incentive programs that typically focus on economically challenged or underserved aspects of the relevant economy. Such programs number more than 100,000 just in the United States, if you were to total up all programs from all government entities. These programs often also include partnerships with industry associations, foundations, and corporations, as well as multiple government entities. Here’s an example of just a few programs, for representative purposes only:
• Federal minority programs
• State economic focus areas
• Regional economically depressed areas
• Local industry focus—like biotech in Seattle
Venture capitalists: Another source of private equity financing, along with angel investors, typically focusing on later-stage companies for a variety of reasons discussed in Chapter Two.
Banks: Most commercial banks do not make loans to young companies because of the lack of assets, operational track record, sales, customer base, and other factors of inherent risk. A small group of banks will extend credit or offer debt financing to a young company after a venture capital round. Some commercial banks do provide a line of credit (LOC) for a small business, but the LOC must be collateralized (secured) with adequate and real business or personal assets, often the business owner’s home. Sometimes banks will loan against accounts receivable or inventory, but generally such lending is done for companies with a strong history of sales and a reliable customer base.
Technology licensing: The term is used to describe the process and underlying documents related to a company’s acquisition of the rights (most desirably, exclusively) to commercially viable technology. Often technology is licensed from a university or other academic or research institute by an entity interested in commercializing the technology. Technology is also often licensed by larger companies from smaller companies that lack the financial or infrastructure capability to commercialize the technology. An example of the latter would be a pharmaceutical company licensing the right to drug discovery technology from a small biotech company. Appropriately licensing technology and actually having the right to use the technology is one of the major issues for entrepreneurs. Often the entrepreneur has either not licensed the planned technology at all or not licensed the proper breadth of technology, or the license contains restrictions, covenants, or requirements that may cause the loss or reduction of licensed rights.
Corporate partners, strategic partners: The best and most likely investor may be a customer or supplier. Entrepreneurs often overlook these obvious potential investors because they fail to think more broadly about these relationships. Your innovation may be best understood by those in the same field, such as vendors and customers.
Corporate investment arms: Through certainly not present in numbers close to those of the heady bubble years, many large public companies still have strategic investment arms that present a possible alternative source of investment for young companies. Companies like Intel, Dell, and Agilent see their investment arms as providing the company with access to cutting-edge technology and aspiring talent complementary to the company’s core platform or future product direction. Investments can be made at various stages of company maturation, but seldom are these investments made at the seed stage. Therefore, strategic partnering is a viable alternative for only a handful of entrepreneurial companies.
Incubator-based financing: Some business incubators have developed a small fund or created a relationship with a small venture fund or other early-stage sources of financing to provide companies graduating from their protection with “launching capital.” This type of capital is defined for purposes of this book as a small investment (often in the form of debt financing) to help a company set up operations outside the incubator. The status of companies at graduation is quite varied since incubators set individualized criteria or milestones. Often these milestones include a certain established customer base, an anticipated revenue stream, product maturation, or third-party financing.
From this list of possible funding sources, you should realize that single-source finance thinking is myopic and not entrepreneurial. Many investors insist that entrepreneurs obtain funding from multiple sources to spread the risk around and to create a multiplier on their own investment. Different funding sources will require different financial information. Sophisticated angels have learned to examine financial assumptions closely and to challenge the reality and practicality of an entrepreneur’s assumptions. This high level of scrutiny requires a thorough understanding of your own financials and the underlying assumptions, as well as the ability to proffer well-organized and complete documents.
How do you find these elusive angels? What are they looking for in the perfect company? The next chapter will look at these important questions.
