November 27, 2001 -
Accounting Tips for Improving Your Chances of Raising Capital
by
Bill Snow
In today's investment climate,
the onus is on the entrepreneur to understand market conditions, to figure out
what investors want, and to realistically present their companies. In other
words, entrepreneurs must mitigate as much investor risk as possible. For
example, take a look at these recent statistics:
-
Venture capitalists are
returning money to their limited partners instead of making investments in low
quality deals (“Some Venture Capitalists Are Finding It May Be Better to Be
Out Than Down,” Wall Street Journal, November 14, 2001.)
-
Less than one percent of venture money went to
seed stage companies in the third quarter of 2001. (“Q3 MoneyTree Report
2001,” PriceWaterhouseCoopers.)
-
In 2001 it has taken much more time for companies
to close rounds. On November 1, John Kirks from Venture Economics reported,
“In today's market conditions, private financings are generally taking longer.
Many venture capital firms are advising their portfolio companies that they
should enter into a private placement effort braced for a six-month process at
a minimum.”
Factor in the virtual shut down
of the IPO market and the recent pronouncement that the US economy has been in a
recession since March 2001, and we are left with a difficult time to raise
money. While the usual venture capital mantra of management team, defensible
technology, scaleable sales and proven model are still applicable to today’s
capital seekers, entrepreneurs who otherwise have venture-quality deals may
unwittingly scuttle their opportunities by proffering financials that break
accounting rules or use faulty and unrealistic assumptions.
While accounting minutia often
makes people’s eyes glaze over, there are a number of accounting-based sins that
I have recently witnessed -- mistakes that are often “red flags” for investors.
Understand the Cash Flow
Statement
I recently spoke with an
entrepreneur who obviously didn't understand the difference between operating
cash flow and financing cash flow. He thought selling a product and selling
stock were the same -- he booked both as revenue. Even though this
entrepreneur previously raised a few million dollars in a series A round and the
company was generating millions of dollars in annual sales, I ended the
conversation because of this basic flaw. I was left wondering what other “holes”
were in his business skills.
Here’s a quick review of the
cash flow statement:
The balance sheet is a snapshot
of a company’s assets and liabilities. The income statement shows the profit or
loss for a particular period of time. The cash flow statement shows the
relationship between the two statements, and it is presented in three parts:
Operating, Financing, and Investing. Operating cash flow is the amount of cash
generated from the operations of the business (e.g., selling your product).
Financing cash flow shows the inflow or out flow of money due to fund raising
(e.g., selling stock). Investing cash flow shows the inflow or outflow of money
due to purchase of assets used to run and build the business (e.g. buying a
warehouse).
Possess a strong balance sheet
before seeking money
Given the fact that closing
funding rounds if taking up to six months, companies should have sufficient cash
on hand to weather the lengthy process. While there are always exceptions,
companies that are “running on fumes” or worse, have missed recent payrolls, may
not have enough strength to attract venture money – they may not be existence in
6 months. The best time to raise money is when you have money.
Proper Use of Goodwill
A few months ago I dealt with an
entrepreneur who’s balance sheet listed $18 million in goodwill. Curiously, her
five-year projections failed to amortize this intangible asset, and nowhere in
her plan could I find mention of an acquisition. The entrepreneur was unable to
explain the goodwill entry until she conference called her CPA, who told me the
goodwill amount was a “plug-and-chug” number created at the behest of the
entrepreneur. The entrepreneur’s goal was to create a higher valuation for her
company. This situation was “red flag” for a couple of reasons:
1.
The entrepreneur failed
to demonstrate an understanding of basic accounting, and
2.
She was unprepared to
answer questions pertaining to the plan she “wrote.”
Realistic Paid-In Capital
Achieving large sales usually
involves a large investment -- plans that forecast sales of $2 billion in year
five, with only $3 million of paid in capital, are highly unlikely. Relying on
retained earnings to fuel this kind of growth will likely lead to severe cash
crunches, some of the reasons include (but are not limited to):
-
Receivables will be collected slower than
expected
-
Not every employee will be a “keeper,” which
reduces sales and increases costs
-
More equipment will be demanded than planned (and
will probably cost more than forecasted)
-
Litigation that often accompanies large companies
-
Changes in the economy
Avoid the Ambiguity of
“Current-Year Revenue”
In their zealousness and
optimism, entrepreneurs often create unintended confusion with regard to the
current year’s sales figure. Last year’s sales are fact, and next year’s sales
are projection. The current year is actually a combination of existing sales and
forecasted sales. A current-year revenue figure of $2 million that is dependent
upon the company closing a $2 million sale on December 31 will be a red flag to
potential investors. For this reason, it is often advisable to state the current
year’s revenue in terms of the run rate -- the most recent month’s sales
multiplied by 12.
Solutions -- Demand Brutal
Honesty
Raising capital is never an easy
process, and entrepreneurs need to remember to do everything possible to
mitigate investor risk. The fact VCs are returning money instead of investing
it should be a siren call to entrepreneurs. Entrepreneurs need
Using the right partners at the
right time can help an entrepreneur mitigate these risks. In addition to finding
quality legal, accounting and marketing providers, insist that your advisors
provide brutal honesty when reviewing your plan. If you work with an accountant
who bends GAAP rules for your appeasement, investors will probably see this as a
warning that there are more problems in your plan, management skills and/or
business operations.
About the author
Bill Snow runs this site. If you haven't figured that out yet, I can't
help you. |