Fatal Flaws

The Numbers Game

The fifth area where entrepreneurs mess up in raising money is inadequate financial reporting of either past results or future projections. It's hard to pinpoint one area where the warts pop up on a financial statement because so many subtleties make up the mosaic of a company's financial picture. But let's start with a few of the more obvious ones.

First, who prepared the historical financial statements? "If the income statement, balance sheet and cash flow statements have been internally generated, as opposed to being prepared by a CPA," says Shuey, "the company is basically unfundable from outside sources until [an outside CPA prepares the documents]." It's not that management isn't capable of generating financial statements. But the use of a CPA brings with it another verification that the company is for real, even if the statements are just a compilation. And if your financial statements are prepared by a "Big Six" accounting firm, so much the better for convincing outside investors the statements are what they say they are.

Another fatal flaw with respect to financials is a profit and loss statement that shows a profit but, upon further scrutiny, indicates a loss is more accurate. How could this happen? Several ways.

For instance, under the guise of "matching" expenses and revenues, many entrepreneurs are tempted to "defer" certain expenses incurred for product development until the product is actually introduced. The net result is that the income statement doesn't show all expenses, hence making profit much easier to attain.

Some companies understate their returns and allowances on sales--which are often extremely large when a company sells to national discount chains, which have a reputation for returning unsold product--resulting in inflated revenues. And sometimes, companies show extraordinary gains and losses from sales of equipment or trademarks that do not appear to be aboveboard transactions.

In short, there are lots of ways to show a profit, even if you're not trying to cook the books. But if you're trying to raise capital, today's net income can be tomorrow's wart.

With respect to IPOs, Shuey says if he sees something in the financials that he feels the SEC will make the company restate, thereby turning what was once a profit into a loss, "the company is unfundable, and we walk."

Finally, many companies render themselves unfundable with unrealistic financial projections. If a company has been growing at 15 percent to 20 percent annually, it's hard to believe it's suddenly going to start showing increases of 40 percent to 50 percent per year. But financial projections even more unrealistic than this are common. You might be able to fool your dotty uncle into thinking you will have $300 million in sales by year five, but a sophisticated investor, particularly one who has run a company, will believe you're simply naive and take his or her risk capital elsewhere.

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This article was originally published in the November 1996 print edition of Entrepreneur with the headline: Fatal Flaws.

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