As promised in the last blog about how to write a “Pitch Deck”, in this blog I will talk more about the importance of Finance and Accounting for your start-up.
We had some investment successes and of course some failures. Two out of three “failures” have failed as much due to poor financial management as due to poor business models. I don’t really understand why so many entrepreneurs underestimate this function. They think it is an “easy” part of the business and that they can easily outsource it. Well, in Latin America especially and if you are operating in several countries, it is quite complex and if you do not understand invoice taxes, sales taxes, and withholding taxes you may think you have a profitable product when you do not have one.
This is what we expect to see BEFORE we invest:
- Professional investors will ask for and analyze your historical financials (of course, provided that you started operations already) and this can make you look good or bad. Honestly, so far, we have invested despite almost universally seeing a very poor performance in this area, but we have learned our lesson and we will not invest in a team with poor financial understanding again unless we can work with existing management to improve the situation.
- So this is what we would like to see when performing due diligence on your financials:
- You have recent financials (even better if you do monthly closings).
- Profit and Loss statements (or Income Statements) reflect the reality and are done according to accounting standards. Remember = P&Ls are based on the accrual concept, regardless of cash movements. Revenue is posted in the month that you provided the service, regardless whether you have been paid. In Latin America, employees are paid a 13th salary or “aguinaldo”. This is an expense that you allocate for in every month, regardless if you actually pay this in December. Simple, right? Well, we never see it done right.
- Balance Sheets: They should include all your assets, including accounts receivables, and more importantly, your liabilities, regardless if the supplier has sent you an invoice or not, regardless if the expense occurred in another country or not. Recently we found that a 3-year old business with institutional investors had almost $200,000 in liabilities off the books.
- Remember, you are asking us for money. We want to make sure you can take care of our money. If you cannot reflect your business reality in financial statements you are really not taking good care of our money!
This is what we expect to see AFTER we invest:
- Some entrepreneurs think that raising money is like dating. During the “romance” time they are insistent, patient and very forthcoming with information. After we invest, they seldom provide business updates and even less quarterly financial reports. We do expect this, especially after the “romance” period.
- After we invest we expect to see:
- Quarterly financials comparing Actuals vs. Budget. We expect all accounting done based on FASB standards (which means accrual basis not cash basis, among many other rules)
- A strong finance person or team who understands the cash flow situation of the company as well as the profitability of the different products or services you are selling. I really think the main reason a company we invested in went bankrupt last year was due to the fact that the CEO had a very poor understanding of the cash flow situation and he pushed a service which was unprofitable once all the costs were allocated. In the end, if your financials do not reflect the reality of your business, you cannot make good and timely decisions. For start-ups which are always cash constrained this is very dangerous.
- Taxes, taxes, taxes. We don’t like them, but professional investors will want your company to pay all legally required taxes (sales, employer taxes, etc). At the same time, there are various strategies to legally optimize and minimize your tax payments.
- Cash Flow Statements: it is important for you to understand your cash flow situation and needs. Your company can be profitable, but you may be running out of cash. In fact, in most instances, the faster you grow, the more cash you need. If you run out of cash, your start-up is over.
- Budgets – every year you need to prepare a Budget and “sell” it to your Board. The excuse that the industry is fast changing, your company is young and you have no idea how to project the next 12 months, tells us we chose the wrong team to invest in. If you cannot forecast the next year and set your strategic priorities, who can?
This is a short summary, but hopefully you now understand that if you don’t know what “accrual” means and you do not understand the concept of “Working Capital”, then you better hire someone who does. If you have a founding partner who understands this, even better!