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To put the early phase of building a startup business into context, consider dating. You remember that, right? Daters find each other through different avenues, get together, gauge their respective interest in one another, and then pursue a relationship or go their separate ways.
If you’re an entrepreneur, you’re following a similar path. You court a variety of concepts, products and/or services until the day you fall in love with a strong business concept. At that point, you may need to find employees to join you in your journey, so you network and continue exploring until you click with the right match.
The similarities don’t end there. To obtain capital, you have to flirt with investors and bankers to demonstrate all the best qualities of your business and convince them you are a respectable partner prior to starting a relationship. There is one aspect, however, of this startup love story that often gets ignored and, unfortunately, is probably the most important element: your financial statements and the underlying data.
For a business owner (or financial director) at an early-stage startup looking for an outside investor, maintaining a sound set of financial statements is not only key to securing capital but is important for assessing the health of your business. Equity investors, banks or any other alternative loan institutions use financial statements to calculate the value of your business, predict growth trends and set loan covenant terms. Current shareholders want to know how the business is doing—or to put it another way, they want insight on returns that are being generated on their investment. As an entrepreneur, producing a set of by-the-book financial statements sends a clear message to investors, creditors and shareholders that you are serious about your business and ready to talk investment.
For startups and small businesses, here are four common financial statement hurdles that must be overcome in order to gain attention and traction from investors and lenders:
Despite what your gut feeling is on the success of your company, you need to produce recurring financial statements for several reasons. For starters, they tell you if you are making a profit or a loss, as well as what cash (if any) you have remaining after paying your bills. Generating recurring (at least quarterly, but ideally monthly) statements can highlight trends and show you areas of your business that may be getting out of control.
For example, periodic analyses of your financials may lead you to understand that you are producing too much inventory and not generating enough sales to cover the costs. Or, perhaps you are making too much of Item A and not enough of Item B, hence, not maximizing your profit potential because you are producing the wrong products at the wrong time.
Additionally, banks will require you to produce financial statements for loan covenant purposes. Certain lenders loan with revenue-based financing, meaning that your company’s repayment of the investment is based on a percentage of your monthly revenue. If you don’t have a complete and accurate set of financials, say goodbye to that funding.
If your business is a software as a service (SaaS) startup, chances are you have a subscription-based revenue model. SaaS subscription-based operations generally have a significant amount of prepaid and recurring contracts or up-front setup fees. If you are not applying the accrual basis of accounting properly, you may be understating deferred revenues or inappropriately recognizing revenues too early.
Loan underwriters and bankers need actual financial data, principally recurring revenue stream(s) data, to determine the risk of investment and the price at which your business should be valued. If you have ever seen the television show “Shark Tank,” the “sharks” are only looking for data on what entrepreneurs have done, not what they think they will do. You need to let your business speak for itself in the form of concrete data or relevant stakeholders will not take your business, or request for capital, seriously.
Taking your business (and your abilities as a fearless entrepreneur) to the next level means understanding how to interpret and wield these documents to determine the performance of your business, as well as what potential decisions need to be made. There are key ratios that every startup should compute to analyze important factors as outlined below.
One important consideration here is that all ratios should be compared against industry standards in order to compare “apples to apples”; an industry with high inventory (such as retail) is probably not best compared against a tech startup that will have higher fixed asset costs and minimal inventory. Here are some important ratios to calculate and understand:
Financial statements may not be the most thrilling things to put together when you’re first starting a business—who wants to report that they’re not making any money? Although you might not fall in love with the process, compiling complete and accurate financial statements will save you a lot of headaches – and maybe even heartache – down the road.
Do you have questions about conquering financial statement hurdles, or other business challenges? Please contact your Marvin and Company, P.C. representative.