Those familiar with the BBC2 show Dragons’ Den will be all too aware of the following scene. The entrepreneur is tasked with presenting his business plan to a panel of investors (i.e., the Dragons). The business plan pitch is going well, and then one of the dragons asks the simplest of questions,
”What was your turnover last year?” The camera pans in, the participant stutters, eventually he declares that he is ”not sure” and before you know it, he is sent packing. Why do entrepreneurs consistently fail to appreciate how important it is to have financials in hand when pitching an idea? Why do they consistently present a business plan without even a rudimentary knowledge of basic financial concepts, such as turnover or margin? This article highlights some of the financials that any aspiring entrepreneur needs to know before submitting or pitching a business plan to a ‘dragon’ of any hue.
Firstly, let’s consider the context. Investors have a range of investment options available to them. While depositing cash in a bank is low risk, it is not the most exciting option and associated returns are likely to be low. Angel Investors or Venture Capitalists are looking for investment growth opportunities that offer the potential of a greater return; which naturally come with a commensurate increase in the risk. The level of risk is dependent on a number of things; the market risk (whether there is a market opportunity and the extent of it) but also risk relating to the decisions made by the agent (i.e. the entrepreneur).
With debt funding such as a loan, the investment is typically secured on some assets and the repayment schedule will guarantee monthly income streams to repay same. When it comes to equity financing, the risk dynamic increases considerably. Why? Because decision-making is in the hands of the entrepreneur, not the investor. An investor must endeavour to ensure that the incentives of the agent (the entrepreneur) are aligned with his or her own. This ensures that investment is not spent on non-income-generating investments or perks. This is commonly referred to as the ‘principal agent problem’ by economists.
Potential equity investors will also be keen to assess whether the entrepreneur will be a competent business manager. To address these concerns, the investor will be looking to not only understand the product and market opportunity, but also to understand the abilities of the management team tasked with delivering the opportunity. Hence, the entrepreneur needs to be confident, knowledgeable, and trustworthy but also au fait with the underlying financials for the business.
In assessing these risk factors, historic data will play a crucial role in the investors’ decision-making processes. Investors will be trying to assess the existing cash generation capability of the company and also the free cash flows that remain once all other obligations have been met. Hence, someone claiming to not know turnover or net profit figures from past trading probably has something significant to hide. If figures are low, that is fine, provided you can explain why some of the figures were not as you would have wished. If you have not begun trading, the risk profile increases dramatically and as a result you should expect an increase in the equity stakes required by interested investors. The three headline figures to be particularly cognizant of are Turnover/Revenue, Gross Profit and Net Profit. The figures for these provide an indication to the investor as to the level of demand for the good or service and also whether this demand can be met profitably. If you have been trading, you need to have a firm grasp on the P&L figures and also a good explanation for the underlying performance to date.
Once you have covered off the key financials, and the “dragon” is willing to invest, the focus will shift to the following:
- The value of the entire business.
- The percentage of the business you are prepared to sell.
- The value of the share.
Use a multiple of earnings or an assessment of future income streams to estimate the value of the business, and then decide what level of equity you are prepared to offer in return for a cash investment. Most investors are pretty sophisticated when it comes to financing, and hence, you will be at a disadvantage. This is their area of expertise; they are seeking an appropriate risk/return for their investment. Their primary interest will be to assess the ability of the company (including management) to generate free cash flows to enable the business to grow while also returning cash to them. It is recommended that you get some advice with this area before you enter the den. It is important that there are no complex structures in place vis a vis where the value lies, the company structure, or existing shareholders. Dragons do not like surprises- so don’t deliver one, especially right at the end!
Finally, it is worth having a walk away point in mind. If the offers from the dragons do not match the valuation you have placed on the company and the stake on offer, be prepared to walk away. If you get to this stage and have some offers on the table, it is likely that you will be able to secure funding elsewhere at a level closer to your valuation.