Does anyone really know what makes a financial projection exciting and believable to investors? Although it's generally understood they don't like "hockey stick" projections--sales projections that start off pretty level, then make a very quick, sharp, almost 90-degree turn straight up into the stratosphere--what is it they're looking for that would convince them to invest? In other words, what are investors looking for in a financial forecast that will convince them you know what you're doing?
The answer lies in a combination of factors, some of which are outwardly visible and others that require some disciplined digging. Let's begin with what we can see on the surface.
1. Time to profitability. A few years back, there was a study done at Stanford University whose objective was to determine if there was a common denominator that would explain the success of NASDAQ's then 100 most successful companies. After an exhaustive analysis, the only factor all companies had in common was that they had all reached profitability by the second year of their existence. Smart investors who understand this key factor won't look favorably on companies that show three to five years of negative profits.
2. Year three and year five sales. Despite a noted aversion to hockey stick growth, investors are even more intolerant of "slow and solid" growth. Why? Because they want to know they'll have a decent return--and possible exit opportunity--in three to five years, and slow and solid doesn't do that. As a general rule of thumb, if a company can't show a realistic path to $50 million in revenue by year three and $100 million by year five, the investment isn't going to fly.
3. Reality check. One of the reasons investors tend to specialize is because they need to know the financial and business metrics of their industry backwards and forwards. Then they need to ask, "Do the numbers fit with what's typical for the industry?" If your answers don't match the industry's standards, they'll quickly lose interest in your project.
And just what are they looking for? Let's get more specific:
- Are the ramp-up projections accurate? If the company says they can have the product in the marketplace in six to nine months, is that a realistic projection?
- What's the projected sales cycle? How long will it take a typical customer to adopt your idea, decide to purchase and then issue a purchase order?
- What are the labor and materials costs and availability? Are your assumptions realistic and accurate?
- What about the size and capability of your competitors? How will your competitors respond to your entrance into the marketplace? Will you have the resources and time to effectively counter their response? Or will they drain all your cash trying?
4. Overall profitability. Once the reality check is finished and all true costs are accounted for, will you be able to operate at a profit? How will that profit compare to the industry standards? How long before it will improve? Since an investor may opt to be paid (in part) out of a percentage of profits, if those margins are too thin, that goal may not be realistic. If so, their interest will wane. What profit percentage is enough? It depends on the industry you're in. In general, however, a one to five percent (EBITDA) [WHAT IS THIS?] is not exciting, and anything over 30 percent had better be defendable.
5. Is there a "razor and blade" connection? Investors like product concepts that require the customer to be put on a regular buying schedule. For example, when you buy a piece of software, you're locked into at least the potential of buying regular upgrades. Products that are sold once and then last 100 years with no maintenance and no upgrades just aren't desirable to investors.
6. Is there room for additional products? No one likes to invest in a one-product company. When presenting a financial forecast, you should be very clear as to when new products will be introduced and what their perceived impact will be on sales and profits.
These six areas can be easily examined by an investor if you take the trouble to clearly present and document them in your financials. The next four areas aren't so easy to see. They'll require careful anticipation and documentation, but you should take the time to do it if you really want to impress an investor.
7. Is there a "lock out" potential that makes this product more attractive? For example, does your company have some type of superior, new technology that totally blows all your competitors completely out of the water and is this technology super secret and protected by an impenetrable wall of patents? Are you the first company to ever think of this idea and now, because you're first to market, you have a huge lead over anyone else? Are the barriers for any of your competitors getting into this market so huge it will take them years to catch up? If so, investors will love you.
8. Are there any regulatory barriers? If you're in a business where there are regulators (like the FDA, FCC, SEC or any state or federal agency that must be appeased before you can move) and you've passed their scrutiny and you're ready to sell and you're first to market, then, once again, investors will love you. Investors like barriers when:
- They're real and substantial.
- The company being invested in is on the right side of that barrier.
- The competition either hasn't yet gotten past the barrier and/or your product is clearly superior.
9. Detailed competitor analysis. Many companies make the mistake of simply assuming their product is superior to every product that exists on the market both now and for the expected future. They fail to even consider that whatever competitors that exist may be just months away from introducing a product that could be far superior to theirs. A seasoned investor will either know or do considerable homework to find out what all potential competitors are working on and to determine how their next product will compare to yours. So, if you really want to impress an investor, do this work for them! Research and hypothesize about every conceivable approach your competition may take. The better handle you have on your competition, the more believable your financial projections will be to investors.
10. Compute the "dead capital" formula. For most product-based companies, there's a formula used by professional investors that approximates how much capital they'll need to invest before the company will be ready for a liquidity event, whether that's an IPO or a merger or acquisition. That formula is referred to as the dead capital formula because it measures the amount of pure "dead" cash that will need to be infused into the company. The formula is this:
(Sales + Capital + Loans) - Expenses = $35 million to $50 million = Time to Liquidity
Thus, if sales are going to be low and expenses high for any length of time, more capital and/or loans will be required (Capital + Loans = Dead Capital). An investor will look at two things here:
- How much dead capital will be required?
- Over what period of time will that capital be required?
Obviously, the less capital required over the shortest period of time equals the best type of investment with the lowest possible risk.
As you can see, a lot goes into evaluating an investment. And if the numbers don't add up, the deal will not get done.