Numbers, Numbers, Who’s Got the Numbers?

By guest author Gerry Langeler from his e-book  “Take the Money and Run! An Insider’s Guide to Venture Capital”

A fundamental part of any startup’s business plan is the financial section, which details the economics of the enterprise. Venture capitalists often see plans where at least half the pages are taken up by spreadsheets showing everything from top line revenue growth to how much will be spent on office supplies in year five. It is remarkable how much more emphasis entrepreneurs place on those numbers than venture capitalists do. The reason for that is simple. Venture capitalists know from years of experience that there are a couple of universal truths in business plan financials.

U R Wrong

First and foremost, your numbers are wrong. All we do not know is how wrong they are and in which direction (although, we can guess). We also know they are not conservative. Most new businesses, even those backed by sophisticated venture capitalists, fail. Even those that succeed usually take twice as much capital and twice as long as their founders and financial backers ever imagined. Therefore, to say a business can go from zero revenue to over $50 million in five years or less and still be projecting itself conservatively, is folly. It is also an insult to the intelligence of the investor audience.

Do a search and replace in your business plan for the word conservative. Replace it with the word “realistic.” You are still wrong, just not as much.

Secondly, we know that most smart entrepreneurs are getting counsel from experienced accountants who tell them that to get venture money, they need to show $50 million in sales by year five and need to demonstrate a good handle on the financial needs of the business. While both are largely true, the way they get played out can backfire. Many business plans seem to work backwards from the $50 million number rather than building up to it.

We see lots of examples of CEOs who can talk about that top line dollar number. Too many do not have any clue on how many product units have to be sold to reach that level or how many customer accounts that translates into. They do not know what kind of sales resources will be needed or what the required average sales per salesperson will be. There is usually no thinking on what the actual sales cycle is and why. In fact, the entire plan is “top down” rather than “bottom up.” No business is ever built top down. It is built out in the marketplace belly to belly with customers while hacking away at competitors.

Go back over your numbers and build them from the bottom up so they make sense. More important, look at that exercise as a way for you to learn more about what areas are key to your business success. If the numbers do not add up to [something] attractive to venture capital backers, better to find out before you even bother with VCs. Go pursue more likely sources such as corporate partners, angels, etc.

There are a couple of real dangers with spreadsheets. First, they let you crunch out detail where detail makes little sense. Let’s face it, you really have no idea what your budget for office supplies should be five years from now, nor does it matter. But a nice formula will provide you a number. Second, spreadsheets have this look of authority to them that makes people believe what is in them must be true. We see many startup CEOs who get passionate about defending their financials rather than defending the underlying tenets of the business. Finally, as the formulas you put in place in the early years play out in later years, they often become silly. You would be amazed how many startups think they will really have 40% net profit margins in year five. Unless the product they are selling is an illegal substance, those numbers are very unlikely.

Your financials should be monthly for year one, quarterly for year two and annually thereafter. Your income statement should pass this simple test: The key ratios a few years out should be no better than those of other companies in the public market in your industry.

Did you hear about the guy who died from dilution?

One of the toughest issues we deal with in early stage investing is overcoming the founding team’s fear of dilution. That fear is perfectly natural, normal and completely misguided. It turns out most of the pushing and shoving on this issue, particularly at the first round Series A stage, gets lost in reality as the company grows and requires additional rounds of capital. Let’s consider the following case:

Most substantial early-stage venture capital firms require 20% to 30% of a company to make their economics work. Most also invest in syndicates with at least one other firm. So, no matter what other valuation and discussions go on, after the Series A, the VCs will own 40% to 60% of the company. Of course, the business plan usually says this is all the money that will ever be needed. But reality says that is nonsense. The overwhelming majority of firms need two or, more likely, three rounds to reach cash flow positive.

So, if the VCs pony up the money for round two, regardless of the progress made, one should expect that financing may consume half the previous one, or about 20% to30% of the company. Round three, again even with nice progress, will require half of that or 10% to15%. So, do the math. At the low end: 40% + 20% +10% = 70% of the company to the investors. The management team owns 30% in the best case. At the other extreme, the investors own 105% (60+30+15), which is clearly not possible.

That brings in the reality of a reasonable floor. We tell all young management teams that the good news is we may be greedy, but we are not crazy. If they don’t have enough incentive to put in the 100 hour weeks, we don’t get paid. In our judgment, that floor is around 20% of the company. If financing events take them below that, we dilute ourselves to refresh management’s incentive. So, in the end, all the fuss and bother about valuation and dilution is about a maximum possible spread between a 20% floor and a 30% ceiling on management ownership at the end of the fund raising process.

The same can hold true on preference stacks.  If after a number of rounds of financing those grow too large to leave management any hope of a payday, investors will usually either reset them to a lower level or put a “carve out” in place to ensure management is properly motivated.

This is why we say, over and over again, “No company ever died from dilution. The ONLY thing companies die from is lack of cash. Optimize for cash – not dilution.” Sometimes the entrepreneurs hear us; sometimes they do not.