Investor Relations:  The Long Conversation

If a stock shows a significant positive change in revenues or earnings with an attendant rise in the price, do you believe portfolio managers will be moved to buy it?

Conversely, if there were a significant negative change in earnings or revenues, would they short or sell it?

Chances are the portfolio manager would not buy or sell.  They would observe, they would take in the new data points, but that might be it.

Remember, a managed fund portfolio might have 50 to 100 positions.  Some have even fewer.  The point is, adding and subtracting positions is the most carefully considered activity a portfolio manager undertakes.  It is, in fact, exactly what they are paid for.  As a result it’s unlikely they will make a change based on a singular data point. read more

How VCs Analyze Financials: Part I, The Income Statement

If you have historical financial statements, your would-be venture capital investor will take high interest in them.  VCs typically look at financial statements differently than other investors, and certainly differently than a lender would.

This three part series will look at the three primary elements:  income statement, balance sheet and statement of cashflows.  Part one, the income statement follows.

(If your company is very early or seed stage, read on regardless, for insights on how to construct your financial statements once expansion materializes.)

The first stop on the income statement are usually the gross, operating and net margins to see if they are in line with industry averages. Next, they’ll tend to look at the trends in contributions to revenues if the company has more than one product or line. Ideally, revenue figures will show a trend toward the higher margin products/services over time.

In addition, most investors will be looking at whether or not the revenues are recurring in nature — that is, are they coming from new or existing customers? It’s much less expensive to generate revenues from existing customers than it is to go out and find new ones. If the revenue structure is a recurring one, it’s easier to make the case for growing margins over time.”

Next, general and administrative expenses. If these are high by industry standards, it’s not necessarily a negative, if you can make the case you’re simply managing income for tax purposes. After all, that’s what small business owners are supposed to do. When general and administrative expenses pose a problem to investors is when the organization is plain top heavy because it’s a sign of management shortcomings.

Next, if there’s not R&D on the balance sheet in the form of capitalized expenditures, then most investors will be looking for some R&D expenses to show up on the income statement. Of course, this mainly applies to technology companies, where innovation offers an edge. R&D can be a very important factor for leading edge technology companies, because innovation is the force that will drive future revenues.  At Intel for instance, R&D was about 21% of its $55 billion in 2015 revenues.

In addition to the overall volume of expenses, says most equity investors will also look at the trend relative to revenues. They’re looking for operating leverage. Ideally, the company is engaged in a business where operating expenses, as a percentage of sales, decrease as sales increase.

Operating leverage is a significant benefit, since under those conditions, the company becomes more profitable, hence more valuable, the larger it gets. For instance, at Apple, the company was able to increase revenues by about $66 billion between 2013 and 2015, with an increase of just $7 billion in operating expenses.  That’s leverage.

Stepping back and looking at the income statement, an investor might wonder if a more conservative approach to revenue recognition would turn what appears to be a profit into a loss. Deferred expenses, questionable gains or losses, low returns and allowances charges relative to industry averages or lax revenue recognition policies might all conspire to make the entire presentation look questionable, or worse, turn a profit into a loss.

Part II, The Statement Of Cashflows will be published next week.  



How VCs Analyze Financials: Part III, The Balance Sheet 

If you have historical financial statements, your would-be venture capital investor will take high interest in them.  VCs typically look at financial statements differently than other investors, and certainly differently than a lender would.

This three part series will look at the primary elements: the income statement, statement of cashflows and the balance sheet.  This is Part III, the balance sheet.  (If your company is very early or seed stage, read on regardless for insights on how to construct your financial statements once expansion materializes.)

Following scrutiny of the income statement (see Part 2), most investors will look over the balance sheet.  Unlike a banker, an equity investor is much less concerned with the presence of assets to liquidate if there are problems. Whatever hard assets there may be, are likely pledged to somebody else anyway.

Most investors will zero in on the intangible assets. Whereas these don’t mean boo to a lender, they speak volumes to an equity investor, especially for a technology-oriented company. For instance, if a company is capitalizing research and development (that is, treating expenditures for R&D as if they bought an asset), that’s good because it shows a significant commitment to product development and improvement, which hopefully will fuel future sales. By the same token if a company is too aggressive in their allocation of R&D expenditures to asset rather than expense accounts, it could be a negative. A more conservative look at intangible assets might cause a reclassification of R&D expenditures as expenses, and in the process deliver a big hit to earnings, and a hit to earnings could cause the next round of financing to be done at a lower valuation, which reverberates all the way back to the VC’s limited partners.

Next, for companies that sell physical products, most investors will look at the inventory to see if it’s in or out of kilter with revenues. If the inventory account is high relative to the revenues, or has been creeping up over time, it can give pause.  Maybe the company is gearing up for a big sale or maybe the company has poor management controls and is not responding to changes in it sales cycle.

Regarding accounts receivable, if there are any, many investors will take an interest in the revenue recognition policies — that is when during the sales cycle the firm actually books its revenues. In general they’re trying to see just how firm the revenues are the company is reporting.  Growing businesses sometimes push sales out the door and book them right away, a policy that can be crippling with complex products or services that may take months to deliver to the satisfaction of the customer.  Technology driven receivables can be particularly volatile because the product or service is new, and customers may not fully appreciate the value they are receiving, or thought they were receiving.

Going over to the liabilities, accounts payable can cause problems. Sometimes a $1 million investment will get whittled down to half than amount after the creditors stake their claim. It’s not unheard of for investors to get on the phone to the creditors to see if they will hang in there a little longer.

Moving down the liabilities, if there’s any term loans, the investor’s comfort with them will vary directly with the length of the term. If its 2 years, that could be a problem. If it’s seven, that’s much better.

Further down in the liabilities section, there are often accrued salaries or ‘Notes Due Founders.’ These can spell trouble for the entrepreneur who is not flexible. Bankers simply subordinate these to their own debts and forget about them.  But equity investors get a little prickly on this topic.  Basically, they don’t want to pay off founder’s loans.  What founders and owners call loans, VCs typically call sweat equity.

Next, the investor will look at the equity section of the balance sheet. First they want to see if it’s negative or positive. Remember, at the end of each year, the net income or net loss gets posted to the equity section of the balance sheet. So if the company has been stringing together a series of losses, the equity will be pretty thin. If the equity account is negative, the company is technically insolvent. At the very least, it’s running on fumes.

Finally, the investor will take a good long look at the notes to the financial statements. In fact, notes are so important, that some investors read them first. Notes to financial statements are one more reason that CPA-prepared financial statements are essential. Internally generated financial statements rarely have them, which has the net effect handicapping the investor, who may simply walk until notes become available.

How VCs Analyze Financials: Part II, Statement of Cashflows

If you have historical financial statements, your would-be venture capital investor will take high interest in them. VCs typically look at financial statements differently than other investors, and certainly differently than a lender would.

This three part series will look at the three primary elements: income statement, balance sheet and statement of cashflows. Part one, the income statement can be found here.  This is part two, Statement Of Cashflows

Following scrutiny of the income statement (see Part 1), most investors will settle down with the cashflow statement. Overall, they want to see how capital intensive the business is, i.e. how many dollars have to be put into the business before one pops out.

It’s not that a capital intensive business is necessarily bad, but rather if a business needs lots of money, the equity investor needs to know it, because he or she is the person everyone is going to turn as the business starts to experience growing pains.

For example, when analyzing the cashflow statements for capital intensity, many investors will look for seasonality. Why? Seasonality eats cash because a business carries inventory that it cannot sell, or maintains staff levels that are not optimized.

Another harbinger of capital intensity is lengthy collection periods. If these are combined with overall increases in the volume of receivables, it means that the company is really getting squeezed. In fact, it’s possible for a growth company to be highly profitable, but cashflow negative every month.

While receivables financing from banks would appear to alleviate some of the capital intensity, that’s not always the case. New products, especially those which are technical in nature, there is uncertainty regarding their reliability, and as a result, market acceptance. In addition, services always make for funny receivables because there is no exchange of a physical product — nothing the seller can take back if the buyer fails to pay.

Because of these characteristics, service and growing technology companies often find receivables financing from banks difficult to come. Often times, it’s the equity investor that has to fork over an extra layer of capital so that the operation can catch its breath, hence the focus on capital intensity.