Ignition Law CFO Zac Brech led an interesting discussion on how to prepare for a funding round and make a strong financial case for investment in the build-up.
How to make a strong financial case for investment
A business’ ability to make a financial case for investment will be fundamental to the success of a fundraise. Investors will need to understand at the outset why the money is needed and how it will be used.
They will also need to be persuaded that the risk is tolerable and that they are likely to make a gain. In other words, a business will need to demonstrate that the investment makes financial sense.
And how can it do that? By telling a strong, believable story.
Central to this story is a set of well-considered financial projections, ideally presented in a Microsoft Excel model that investors can modify and adapt. In general, financial projections should:
- Highlight how and when the funds will be used (investors will expect that most of the money invested will be spent),
- Evidence that the money will keep the company solvent for a sufficiently long period of time (long enough for the business to survive until the next anticipated funding round, or for the business to become financially independent).
- Demonstrate that the company will increase significantly in value within a reasonable timeframe (in other words, the projections must incentivise investors).
- Incorporate a range of reasonable and specific data-driven assumptions (this can be key to credibility).
- Align with all the other qualitative and quantitative information and assertions included across any other components of the pitch, including the pitch deck (investors expect consistency!).
How to approach assumptions in a financial model
There are certain mistakes businesses can make when defining the assumptions that underpin the financial model. Whilst overly cautious assumptions might put investors off (as this can indicate that the team lacks belief or a desire to place itself under too much pressure), the mistake that we most often see centres on assumptions that are wildly optimistic, and therefore wholly unrealistic.
It’s important to strike a balance, perhaps settling on assumptions that are arguably optimistic, but achievable.
Businesses also often underestimate future costs, which can suggest some level of naivety in respect of what it will take to achieve their objectives. When determining cost projections, consider looking into the costs incurred by similar businesses pursuing comparable objectives, as well as speaking to anyone in your network who might be able to provide relevant insights.
Perhaps also build in some contingency costs – a separate line of costs to cover anything which might have been missed or underestimated. This might be 5-10% on top of the costs which you have scheduled in detail.
This could all help you to justify your cost projections if prospective investors want to delve into these in more detail further down the line.
How can you test projections for a unique product or service?
If your offering is unique, meaning there’s no existing market and/or no obvious benchmark out there against which to test your projections, what can you do to alleviate investor concerns? Well, investors will still expect you to go through some kind of exercise to quantify the opportunity, albeit one that’s less objective than would be the case where a similar business model or an established market already exists.
Either way, there needs to be some degree of quantification that’s at least vaguely justifiable (i.e. not overly ambitious, and with somewhat reasonable assumptions).
For instance, if you were introducing a new app for dog owners, you might start with data on the number of dog owners in the country, segment this data to identify how many might be potential app users (e.g. on the basis of age), and assume penetration rates (perhaps based on rates achieved for other apps), to reach an estimate of the number of users you hope to acquire.
What do investors look for in terms of ownership and capital structure?
A company’s ownership structure, including its capitalisation table, is a critical piece of the puzzle for investors. After all, this will ultimately determine their ownership stake post-investment (and therefore impact their return on investment further down the line).
A prospective investee (and any business for that matter) should therefore maintain a full and accurate record of all shareholdings and share classes, plus any other ownership-related interests such as advanced subscription agreements, convertible securities, options, and so on. Any confusion or perceived lack of transparency will likely be seen as a serious red flag.
Plus this information will be needed to populate some of the legal documents required to complete a fundraise anyway.
Financial due diligence
Whilst projections are important, historic financial information is also key, and this is where financial due diligence comes into play. This is the stage in the fundraising process where investors will take a closer look at a prospective investee’s financials, although the extent of the financial due diligence exercise will depend on the nature of the investor and the size of the potential investment. It’s often a question of what’s proportionate in the circumstances.
For example, professional investment funds considering large investments into scaling businesses are likely to require detailed financial information, and may even put together a team of external specialists to help analyse the figures. In contrast, an angel investor considering a minority investment as part of a pre-seed or seed round might require only basic accounts (which they will review themselves), especially if the prospective investee businesses is pre-revenue or only just starting to sell.
Investors will generally look for:
- Financials that are up to date: these should be well-presented within a recognised accounting system (e.g. Xero).
- Management accounts: these might be filed on a monthly or quarterly basis, and should ideally include some commentary to give context to the numbers. It’s worth trying to anticipate in advance how any such commentary might be perceived by an investor (e.g. whether any explanations might be considered red flags), and potentially offering to talk investors through the numbers before sending them any accounts to review in detail in their own time.
- Year-end accounts: these should be consistent with other numbers provided.
- Accountability for the numbers provided: someone from the investee business needs to take ownership over the numbers, and be available to investors to answer questions and address any concerns.
Key steps when gearing up for a funding round
There are various steps businesses can take before commencing a funding round in order to ensure a smooth process moving forward, some of which can help to convey that the business is well-organised and that investors’ money will therefore be properly managed. Such steps could include:
- Setting up a virtual data room that is fully populated and well-structured: this gives a prospective investee more control over the information, as they can control access and permissions. It also enables a prospective investee to quickly and seamlessly make the information available to multiple investors at once (which is often much more efficient than sending documents via email to each investor separately).
- Preparing a document of frequently asked questions: anticipating questions and providing easily digestible responses in this way can demonstrate a willingness to take the initiative, whilst saving time by avoiding the need to answer the same questions multiple times for different investors. This approach can also help to ensure that investors receive consistent information.
- Compiling the key numbers before you are asked to do so: historical, month-by-month numbers (potentially 3-4 years’ worth) could be included in a separate tab in the spreadsheet that contains the projections. Again, this can demonstrate a willingness to take the initiative, whilst also evidencing a desire to be transparent.
Zac is Ignition Law’s CFO and provides financial advice to clients through Ignition Financial.
In a 15 year career as an M&A banker at Credit Suisse Zac advised on some of the biggest deals of the early 2000s. in 2014 he went on to co-found an enterprise software company.
Zac acts as a fractional CFO and corporate finance adviser to growth and professional services companies.
If you need advice in connection with a fundraise, or on any other corporate/commercial matters, please contact Ignition Law via firstname.lastname@example.org. If you would like to attend one of our future sessions, please contact Tammy@ignition.law.
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