In a previous blog where I describe how companies will live or die based on their spreadsheets, I talked about several examples that would raise the red flag to any investor. One flagrant example came to my attention recently not mentioned in that blog, yet equally important. The startup company had put together several years of revenues and expenses. During a presentation, the investor commented that he preferred to see the details to the projections shown earlier.
When I inquired the CEO for me to look at the spreadsheet that led to the annual projections, I discovered that the expenses were only tracked on a quarterly basis and the revenues were based on an annual basis. I then asked, where were the monthly numbers? – they did not exist! His team decided to throw caution to the wind and only put together a sketchy balance sheet.
A month-to-month setup is critically important. Now whenever a professional investor makes a financial commitment to a company, they will monitor that company on a monthly basis to see the variances from the projections. With the monthly model, the investor can determine the capital needs per quarter or semi-annually.
Contrary to what many entrepreneurs believe, once an investor states in the term sheet that it will invest one million, as an example, it does not mean that the company will get its one million in one shot. In fact, they dispense the cash in chunks and then see how that works. Why? If the company fails to deliver after several months whatever product or sales, the investor might reconsider walking away or undertake some additional actions. In some term sheets or investment documents, the entrepreneur’s equity percentage might even change as a penalty for not meeting the projections.
The monthly model represents to the investor whether that entrepreneur bothered to do a due diligence on setting up a budget. At another company, I informed the entrepreneur what was the monthly budget for an office, for paying standard legal fees for various legal matters, and the monthly costs of an outside accountant? Getting these figures right shows to any investor that the entrepreneur has some experience in running a business and/or made the effort to find out what it costs. Interestingly, that entrepreneur simply ignored putting that budget together. To me, that represents a blatant inability to run an enterprise. No experienced investor would place capital at risks for such an entrepreneur. Cash flow is the life blood of a company. The month-to-month model reveals the pulse of that company.
Currently, I am working with a medical device development company. Part of the analysis to get monthly figures is determining what are the incremental costs for embedded electronics? I also asked questions from the engineer how long and how much for the development costs for a Beta. How many units need to be manufactured to get a decent incremental cost. With this information, I can set up a decent budget on a monthly basis that includes the capital expenditure for the product, the number of months for development, the COGS of the product by units and in months. Then, it is a simple exercise to make a quarterly and an annual model. With these details, I am prepared to answer any questions during due diligence regarding the pre-production costs for the product. The investor will now know where his investment is going for the first six months and how much of the total investment can be allocated over several quarters.
If an entrepreneur needs to gain the confidence from a potential investor, the best way to do so is setting up detailed financial models. It demonstrates to the investor the entrepreneur’s knowledge and experience in the market sector. Without such details, it is a very risky proposition to present a sketchy business model to any investor.