Mutual Needs:
• Retention of key management
• Forum for conflict resolution among investors
• Health of post investment company
• Tax consequences of investment

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Entrepreneurs seeking capital from investors frequently find that the financial projections they provide are broken down and analyzed using ratios. Every investor has their own idea of what is important and what ratios best reflect that aspect of performance. Many times the task of keeping up with these and understanding them proves tedious and time consuming for an entrepreneur that has a business to run. I advise entrepreneurs faced with sorting out this type of information to think of ratios in five broad categories.

First of all there is profitability ratios. This category includes ratios such as return on equity, return on assets, earnings per share, return on sales and, In short these ratios express net income in terms of a percentage when divided by a chosen return criteria.

Next there are solvency ratios. These help an investor determine the ability of your company to meet near term financial obligations. The most popular solvency ratio is called the quick ratio which is the sum total of your cash, marketable securities and accounts receivable (from your balance sheet) divided by current liabilities (also from your balance sheet and typically defined as obligations due within 30 days).

Activity ratios give investors a sense as to how fast assets turnover within your company. This also gives important insight into cash flow. For example, receivables turnover (credit sales divided by average accounts receivable) calculates the rate at which receivables are collected. A higher number indicates that you are collecting receivables more quickly and are hence bringing cash into the company more frequently. Likewise inventory turnover (COGS divided by average inventory) give an investor a sense of how efficiently inventory is being managed. A high inventory turnover means that product is being sold much sooner after hitting the warehouse and hence turning into cash more quickly than a product that lags in inventory before being sold.

Capitalization ratios such as financial leverage (Return on Investment – Return on Assets) and debt to equity gives investor a sense of importance of debt and equity in your company’s capital structure.

Market ratios are very important to investors as they will ultimately play a part in the value an investor places on your company and the amount of stock they will require in exchange for investment. Two very important market ratios that companies seeking capital should understand are price to earnings and return on investment

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One question that frequently arises among entrepreneurs when seeking capital for their business is “how will investors interpret the financial statements that I provide in my business plan?” It’s a good question and something every entrepreneur should understand when dealing with investors, whether they be angels, venture capital, hedge funds private investors or any other source of funds. Let’s talk briefly about the balance sheet.

The balance sheet is a snapshot, if you will, of your company’s financial position at a given point in time. It is expressed in terms of assets such as cash, receivables and physical items owned by the company, liabilities, or money owed by the company against those assets and stockholder’s equity which represents the initial investment by owners and any past profits that have been retained in the business.

The balance sheet is aptly named because the assets of must equal the sum total of liabilities and stockholders’ equity. Said another way, a company’s assets less its liabilities is the stockholder’s equity in the company. Obviously, this is a very important indicator a company’s overall value to an investor.

An investor that is considering funding your company will look to the balance sheet to get an indication of your company’s financial strength. The investor will look at assets to see what your company owns. Large amounts of cash and marketable securities, sometimes called liquid assets or current assets, are attractive as they give a positive indication of the ability to meet near term obligations. Other assets such as intellectual property and brand names could also be attractive because the potential to monetize those assets is sometimes substantially more than the value reflected on the balance sheet. Large amounts of goodwill, or the amount you may have paid for your company above its book value, relative to total assets could be a red flag due to its intangibility and illiquid nature.

A view of your company’s liabilities gives an investor a picture of leverage, the amount of debt your company is carrying relative to your company’s net worth. In other words, if the company were forced to liquidate could it pay all of its bills and have something left over for them? A close examination of your company’s liabilities will also give the investor an indication of how much cash will be required to meet near term obligations and, by comparing to assets, your company’s ability to meet those obligations.

In addition to telling a potential investor how much equity the owners have in your company the stockholder’s equity section of your balance sheet will also give an investor insight as to how much money has already been injected into your company, the number of outstanding shares in your company’s stock and your company’s use of earnings. The line entitled additional paid in capital and shares outstanding lines plainly tell an investor how much capital has been put into your company and how much stock you had to issue in return for this capital. The retained earnings line will tell an investor how much of past earnings you have retained in the company. A historical analysis of the retained earnings account will also give an investor hints regarding dividends.

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Let’s take a few minutes to discuss two major cost categories from the perspective of an income statement, cost of goods sold, sometimes called COGS, and overhead. When an investor is reviewing your historical and pro-forma income statements they will want to understand which costs are necessary to provide the product or service you sell and which cost support your business from an administrative standpoint.

Cost of goods sold, many times called COGS for short, is the sum of all costs directly associated with the product or service your company provides. This could be items such as raw materials and labor for a manufacturer, the cost of inventory for a retailer or cost of delivering web based services for a technology company. Cost of goods sold is important to an investor because subtracting this number from revenue allows them to determine how much raw value, if you will, your product creates (called gross margin) and how much your company can afford to spend on overhead and still generate an acceptable return.

Overhead, sometimes called indirect costs, is the sum of all costs of doing business not directly associated with providing the goods and services your company sells. This could range from accounting costs to legal costs to insurance to rent to salaries for management. It is important for an investor to understand overhead so that they can determine how much cost can be curtailed in times of slumping sales or falling prices without compromising the base function of delivering goods and services.
A detailed understanding of cost is important for investor and manager alike so that your business can perform most efficiently and maximize return by continually eliminating excesses.

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Let’s take a minute to talk about your company’s income statement. The income statement, by determining profit, measures the success of your company’s operation over a given period of time. Plainly put, the ability to consistently generate profits is the ultimate indicator of your company’s viability.

The income statement is divided into two sections, revenue, the money generated from the sale of goods and services, and expenses, the money it costs you to generate those goods and services. The dollar difference between these two sections is called net income, earnings or profit.

Revenue and expenses are generally divided into sub-categories so that investors can more easily understand how businesses generate revenue and incur expenses. For example, if your company generates revenue by selling products and providing services it is a good idea to show an investor how much revenue comes from each source.

Likewise, expenses are generally incurred in two ways, those directly associated with providing goods or services such as raw materials or labor, generally referred to as direct costs, and those associated with supporting operations such as rent and management salaries, typically referred to as indirect costs. The sum of all direct costs is referred to as cost of goods sold, sometimes called COGS for short. The sum of all indirect costs is typically referred to as overhead.

An investor will want to see your income statement broken down into the appropriate revenue and cost categories so that they can determine your gross margin, revenue less cost of goods sold, and understand how much of that is required to support overhead before delivering a return in the form of profit.

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A common question is, “What type of capital structure is best for my company?” The answer to that question is individually dependent upon your company, its stage of development and its needs. In the broadest sense there a two types of financing, debt financing and equity financing. Let’s take just a minute to consider the broad implications of both.

Debt financing is the infusion of capital by an investor in exchange for an agreement or repayment and interest over a specified period of time. Debt is usually backed by collateral and subject to other restrictions the investor may impose to secure their position. Common examples of debt capital are loans and the issuance of bonds. Debt may be an attractive means of securing capital for your company because you are not required to give up equity in exchange for the infusion.

However, carrying debt on your balance sheet requires that you have sufficient cash flow to make periodic interest payments, projected resources to pay off principal at the time of maturity and collateral necessary for securitization. Debt financing is many times not an option for early stage companies because of lack of positive cash flow. An exception could be debt put in place alongside owner’s cash for the purchase price of hard assets, such as plant equipment or real estate, that’s liquidation price would be sufficient to cover the amount of the loan

Equity financing is the infusion of capital by an investor in exchange for stock in the company. Equity issued to investors in exchange for cash can take many forms such as common stock, preferred stock or warrants. Common equity investments are those made by venture capital funds, angel funds and hedge funds. Whatever the agreement structure, equity investors expect a return in the form of dividends and appreciated stock value at the time of a company sale or public offering.

Equity financing may be attractive because it allows for an infusion of capital into your company without the immediate cash obligations associated with debt service. Additionally, bringing in equity investors means that you’re bringing in new owners and possibly new board members which may a change in the corporate culture. Many times these new owners are experienced businesspeople in their own right and can offer management valuable insight and perspective as your company grows and changes.

While equity financing does not make significant demands on cash flow, except when dividends are paid, it can come at a high price. Equity investors take on a lot of risk when investing in your company at an early state but generally reap handsome returns on their investment at the time of company sale or public offerings.

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Let’s start off this vital part of any capital formation strategy and talk about the building block of your company, its telltale value and how well the company is doing…by its financials.

Entrepreneurs seeking funding and preparing business plans frequently ask me to explain the concept of pro forma financial statements. It’s a very important concept and is a critical part of any business plan.

Pro-forma financial statements put your vision for your company into language private investors to understand: dollars and cents. Pro-forma, in this context, is another word for forward looking. Therefore, pro-forma financials state the financial results that your business plan is expected to generate. This includes a complete set of financial statements which are a balance sheet, income statement and statement of cash flow, and looks out three to five years.

Generally speaking, the first year, when assumptions are more clearly defined, financials are expressed on a monthly basis and the remaining years on a quarterly basis.

Making assumptions about your business and market place is perhaps the most important part of assembling pro-forma financials. Investors generally give more credibility to “bottoms up” assumptions as opposed to “tops down”. An example of a “tops down” assumption is estimating a market size at say $200 million and assuming that your company will get 5% market share for annual sales of $10 million. A more credible “bottoms up” approach would be to assume that you will initially hire five sales people who will each realistically call on two clients per day, close 30% and make annual sales, on average, of $2 million for a total of $10 million in annual revenue.

Macroeconomic assumptions are also a very important element in assembling pro forma financial statements. When seeking funding the entrepreneur must demonstrate a firm grasp of how the larger economic environment will impact their business. For instance, is your business sensitive to changes in energy prices? If so, then what are your assumptions about the coming months and years? Will your business be impacted by changes in the housing market? If so, then what do you think about the near to intermediate term housing market?

When analyzing your business plan investors will realize that your pro-forma financial statements are based on assumptions and will discount accordingly. However, it is important to show potential investors that you have given careful consideration to the real forces that drive your business. The confidence you inspire will go a long way in establishing credibility.

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One question we almost always get at the Capital Match Point is, "What's on the mind of our investors?" And the honest answer to that is, "A lot." But one thing you can count on that's front and foremost in their mind is the value of your company. The reason they're interested in that is because they want to see how much equity in your company they're going to get in return for a capital infusion, and they're going to go about that in several different ways.
One method that they're going to commonly use, though, is what's called the price-to-earnings ratio. And what the price-to-earnings ratio is is it's, quite simply, the price of your stock divided by the earnings per share of your stock over a 12-month period. For example, let's say Company A's stock price is $20, and let's say the most recent annual earnings for Company A was $2 per share. The price-to-earnings ratio of Company A is 10. Now, the way our investors are going to use this information is, they're going to go out, and they're going to do some research on publicly traded companies in your market space, and they're going to look at an average of price-to-earnings ratios across those companies, and they're going to arrive at what this industry can support, and then they're going to make some determinations about how long it's going to take you to achieve sufficient revenue and sufficient earnings to execute an exit plan, and they're going to make some assumptions about what the stock markets at that point and time are going to have an appetite for in terms of public offerings or sales, and they're going to accordingly assign a price-to-earnings ratio to your company. And it's also important for you to understand this, because what you want to do is, you want to do your own homework so that you can go and, when the time comes, negotiate with the investors and really be prepared to defend the value of your company, because, after all, you're going to be giving up a portion of your equity in your company in exchange for the cash infusion.
And if you think you need help, get in touch with us at the Capital Match Point. That's what we're here to do. We're here to put you in the best position to negotiate when the time comes.

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Entrepreneurs always ask, "What's the value of my company?" And I usually respond to that question by saying, "Maybe the correct question to ask is, 'What's the value of your company to our investors?'" And that answer is not as straight forward as it seems, because a lot of the entrepreneurs that we deal with here at the Capital Match Point are emerging growth industries, and one of the most common methods of determining the value of a company is a price-to-earnings ratio. Well, in emerging growth industries, the market is usually not defined enough such that there is an earnings history that you can go back and make a real price-to-earnings estimate for companies in that market space. So, a surrogate the investors sometimes use is the ratio called the price-to-sales ratio. Price to sales is very similar in its calculations to price to earnings. Let's take Company A for example. Let's say that Company A's stock price is $20, and let's say that the most recent 12 month period, Company A had sales of $20 per share. Company A's price-to-sales ratio is one. Now, an investor's going to take this information, look back, and, instead of going out and digging up price-to-earnings information on companies in your market space, they're going to look at price to sales, and they're going to use this as an indicator of value of your company, which is ultimately the indicator of what they're going to be willing to accept in terms of equity in exchange for a cash infusion in your company.
It's important to an entrepreneur to understand what their price-to-sales ratio is, again, especially if they're in an emerging growth industry, because they want to be as well prepared as possible when the time for negotiation comes.

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When discussing financials with capital seekers and preparing the financials for the whole capital raising process, we generally get to the subject of distinguishing between fixed cost and variable cost. It is important to know this, because it conveys some very important information to investors.
First of all, let's talk about what fixed cost and variable costs are. Fixed costs are just as the name implies: expenses that are fixed. These are expenses that you have no matter what your sales are whether they are good one month and bad the next month, the rent is going to be the same, the management salaries are going to be the same. There are a lot of costs of this nature. Variable costs are, as its name also implies, costs that are variable with the level of sales. Examples might be sales persons' commissions. This is a cost you do not incur until a sale is made. If a company makes sales on credit cards, the merchant fees that a credit card company charges are not incurred until that sale is made.
The distinction between fixed cost and variable cost are important, because it helps investors to determine two very important financial ratios when evaluating a company; the burn rate and the break even analysis. The recommendation I always make to capital seekers is, if you do not feel comfortable categorizing your costs between fixed and variable, give us a call at the Capital Match Point. We deal with this a lot, across a lot of different industries, and we will be happy to help. Because at the end of the day, we are in the business of maximizing the opportunities of capital seekers to get that funding.

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