Avoid These Six Novice Mistakes When Pitching Venture Capital Investors
Build More Credibility with Venture Capital Investors by Getting These Six Things Right in Your Financial Model
1. Unrealistic Revenue Ramp – You may feel that if you don’t show sales of $100m - $200m+ in Year 5 that you may not be exciting enough for investors, but it’s unreasonable to see a plan with that level of explosive growth if you can’t properly articulate how to get there and if your model doesn’t include all of the implications of that kind of hockey stick performance such as copious amount of venture capital, tremendous sales and marketing infrastructure, and deep losses for extended periods of time (consider the fact that Salesforce.com has perpetually lost money with only periodic bursts of profits and spends 50% of Revenue on just marketing expenses). But the issue isn’t just the level of revenue in the “out” years, it’s also several other revenue-related items.
Many plans show revenue in the very first month, even though a lot of groundwork, product development, and marketing are often needed to presage those sales. I’m much more impressed with a plan that shows a launch and preparation phase of a few to several months prior to anticipating any revenue, especially if there is a long product development cycle and sales cycle. Let’s face it: if you have a six-month sales cycle (e.g. it takes 6 months from generating a lead to closing a deal), it’s ridiculous to model any revenue in Months 1 – 6.
Further, many startups build a sales forecast assuming that competitors will never take a bite out of their market or that prices will never be affected. The harsh reality is that competitive advantages will always get competed away and pricing almost always experiences competitive pressure. Startups should plan on lots of market “noise” from new entrants and copycats that will dilute their marketing efforts and at least raise your cost of customer acquisition.
Be careful not to show a plan with cushy annual price increases and ever-increasing growth rates. It’s just not credible.
2. Unreasonably Low Level of Employees and Related Expenses – Starting out with a blank slate and trying to guess at what it takes to build out your idea is hard, and one of the most difficult parts is trying to figure out how many employees are required at various stages of your plan and growth. But getting this wrong can be a real hit to your credibility. I recently reviewed a financial model that showed hundreds of millions of revenue with only 35 employees in Year 5, clearly not a very detailed plan on the staffing model.
But the fact that it is difficult to predict and connect your employees to your revenue gives you an opportunity to impress your investors if you use a high degree of rigor in your financial model.
Because it is highly likely that the vast majority of your headcount will be driven by your revenue scale, it’s important to have a bottoms-up unit economic model where you can tie direct labor, direct sales, and direct customer support to each offering to ensure that your headcount automatically grows in proper alignment with your revenue.
Additionally, many plans completely leave out or at least greatly underestimate the employee-related expenses. Adding an employee is far more costly that just their base salary and in many cases will range between 35% to 50% or more of the base. And, importantly, these employee-related expenses have many different methods of scaling: some are annual expenses, some are flat, some are a percentage of base salary, some are one-time upon recruiting, some are related to turnover, etc. Some should be accrued, such as bonuses. It can be a daunting task to model all of this to be sure.
However, we made this very easy in our Startup Financial Model: users input over a dozen employee-related expenses just once and the model automatically applies those assumptions to all employees across four different types of employees and even automatically accrues items such as annual bonuses and properly reflects the impact on cash and the liability on the Balance Sheet. And if you don’t have time to research all of those inputs, with one click of a button, we pre-populate all of those 50+ assumptions for you based on our market research. Easy peasy.
3. Sky High Earnings – I cannot even begin to count how many startup financial statements I’ve seen that show Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) rates of 50%, 60%, 70% and even 80%+ in the “out years”, such as Years 3, 4, and 5 of their plan. Literally, almost every single startup pitch I’ve seen has such ridiculously high earnings rates.
What’s so crazy about that? We’ve already pointed out the example of Salesforce.com, so let’s consider the fact that even the largest, highest-scale, most valuable and profitable companies on the planet don’t come close to that. In the most recent full year’s financials available as of January 2017, the top seven most valuable companies in the world looked like this in terms of their EBITDA:
#1 Apple was at 27.8% EBITDA,
#2 Google was at 26.2%,
#3 Microsoft was at 23.3%,
#4 Amazon was 3.4% EBITDA,
#5 Facebook was at 34.7%,
#6 Johnson & Johnson was at 27.5%, and
#7 Coca-Cola Company was at 19.6%.
When I scan a startup’s financial summary as a potential investor, one of the first things my eye is drawn to is the EBITDA % they are forecasting. It’s my quick credibility check. Trust me: please don’t show an EBITDA over 30 – 35%, even in Year 5. Ever. Potential investors will be impressed if you have a deeper sense of what’s reasonable on the big picture level and if you can speak fluently about analogous business models and realistic earnings.
4. Woefully Inadequate Levels of Capital Investment – Most entrepreneurs dramatically underestimate how much capital is required to fully fund the build out their solution, invest in sales and marketing, weather a downturn, hit breakeven, and reach the projected growth rates. I am one of them.
After having launched a dozen or so other startups, I launched a venture-backed company 13 years ago that is instructive. My financial model suggested a $1m initial investment in the software infrastructure, followed by a $0.5m/year software maintenance expense. I poured all of my wisdom of having already been a software CEO for several years into my detailed financial plan (the precursor to what the Startup Financial Model has turned into). It would be kind to say that I was off by a mile. Yes, the company has grown into an Inc. 5000 company operating in 20 states, but our initial expense was $2m -- not $1m -- and our annual upkeep, updates, and extensions have continued at the rate of at least $2m per year over the history of the company. So, in sum, my “plan” (and it was a rigorous plan) for the software investment/expense for 13 years would have been $7m, but the reality has been $26m, nearly 4x higher than my plan. Ouch.
One of the biggest issues for an entrepreneur that underestimates how much capital they need only becomes clear when they have to go back to their investors to get more money. It’s the quickest way to lose credibility with your board, go through a down round, and suffer massive dilution. Trust me, you don’t want to go there.
5. Astronomical Investor Returns – Part of the issue with these mistakes is that they compound when combined. If you’ve overestimated your growth and earnings rates, underestimated expenses, and underestimated your capital requirements, you will naturally end up with greatly inflated investor returns. I saw one plan recently that showed the Preferred Series A investors getting a 92x return in five years. Yes, that can happen once in a great while, but it would be much more reasonable to show a 5x to 20x return. It just looks plain silly to have a financial model that shows some astronomical number that everyone will know is a total moonshot.
One of the features I built into the Startup Financial Model is a Cap Table and a very detailed investor return analysis by investor class, from Seed investors to Preferred investors, both Series A and Series B. This gives you the kind of analysis that enables you to make the necessary changes across the landscape of your plan to quickly and easily create rock-solid output that gives you more confidence as you pitch and hopefully leaves your potential investors with nods of appreciation.
6. Weak Support for Assumptions – Business plans and financial models are all about making assumptions such as the size of the market, customer switching behavior, website visitor conversion rates, free trial conversion rates, customer acquisition cost, pricing, contract term and retention rates, billing and working capital assumptions, salary and benefits assumptions, etc. Your financial model is your chance to show the robustness of your thinking, which is an indication to investors of the potential quality of your execution. But yet this is an area that is often alarmingly inadequate in most business plans. When asked where a specific assumption came from, you don’t want to stumble for the answer or admit that you just pulled it out of thin air.
When I was in the middle of raising $12m in venture capital in the 2002 – 2003 post dot com crash era (when it was almost impossible to raise capital) for the Inc. 5000 company mentioned above, my financial model included scores of critical assumptions. In the notes section of my model, I included a detailed table for each of those core assumptions that showed my market research: the source of the information, the data from that source, and then a bottom-line weighted average of the data. That average for each assumption was then entered into the model. Every single one of those core assumptions had at least three inputs from three different sources, while some had as many as a dozen sources. And while I did get many turndowns from potential investors – which is typical – I usually got lavish praise for the depth of explanation behind each assumption. (As mentioned earlier, that financial model I built for that business and the unique way it was constructed on a unit economic basis became the initial version of the Startup Financial Model.)
At the end of the day, I’m not the type to just criticize or point out novice mistakes that many entrepreneurs (including me) have made, but my heart is to always help, which is why I created and commercialized the Startup Financial Model. My hope is that it serves you well in your endeavors to successfully plan and launch your venture.