This is part of GoingVC’s Research Series on Venture Capital Due Diligence
The value of any company is nothing more than the present value (i.e. today’s value) of all future cash flows. Of course, knowing these future cash flows is the challenge, so investors who look to value companies can use different models and means to estimate a company value, ranging from simple back-of-the-envelope methods to complex valuation models.
A key question for VCs is knowing when the company is ready to raise capital. While the company may have passed your screening process and has a great team with a superior product, looking at the company financials is a real opportunity to look under the hood and see how successful a business may truly be. This is where you can better understand how well the company is executing when it comes to what matters most: generating cash.
In our review of Financial Due Diligence, we will first walk through Finance and Accounting 101 and then we’ll dive into the most common VC valuation methodologies.
There exist plenty of materials to give you the basics of the income statement, balance sheet, and cash flow statement, but for VCs it’s helpful to look at the company financials throughout the due diligence process broken down into the sources (from where is capital coming) and uses (where will it be deployed) of cash.
The Income Statement (Revenues and Profits)
The income statement shows the profitability of a company over a specific time period, and is essentially nothing more than what the company earned minus what it spent and is laid out as such:
|Cost of Goods Sold||$3,000|
|Selling, General & Administrative||$2,100|
|Research & Development||$1,000|
|Income Before Taxes||$3,000|
Revenue: Often referred to as gross revenue, simply the amount of money the company brought in through selling its products or services.
Cost of Goods Sold (COGS): Also referred to as the cost of revenue, COGS (pronounced ‘cogs’) is the cost to the company of purchasing the goods or the labor and manufacturing expenses related to the products or services it sold.
Gross Profit: The difference between the Revenue and Cost of Goods sold. Gross Margin is the first key profitability metric generated from the income statement and is calculated as the Gross Profit / Revenue. Companies that have durable economics benefit from high gross margins (40-60%+), as this is evidence of strong pricing power (meaning a company can generate strong profits from their input materials). Conversely, companies with low gross margins mean they are often competing on price – which lowers their eventual profitability.
Operating Expenses: These expenses are those associated with research and development, running the business (compensation and general expenses), and other accounting charges such as depreciation and amortization of capital expenses. For VCs, the most relevant for early stages are the Selling, General, and Administrative expenses – i.e. employee compensation and sales and marketing – and Research & Development.
How realistic are the compensation figures modeled in the financial proformas and does headcount expectations match revenue growth? How aggressively does the company need to spend on marketing? Similarly, for companies that are manufacturing products, how adequately do revenues cover ongoing R&D? High amounts of R&D should be expected for early stage companies, and it should in fact consume the majority of capital.
Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA): Subtracting the operating expenses from gross profit yields EBITDA, a look at a company’s operating profits before the effects of depreciation and taxes. EBITDA and EBITDA Margin (EBITDA / Revenues) is a great profitability measure to compare across companies because it is free of any accounting items that may be unique to a specific company or are one-time in nature.
EBITDA is also a common metric used in valuation when using multiples. For example, a common EBITDA multiple in the industry may be 7x. This means that on average, companies exited at a value of 7x their EBITDA, so if a company has a $10M annual EBITDA figure, the current valuation using the industry EBITDA multiple would be $70M.
Depreciation & Amortization: D&A is likely ignored for most early stage companies, especially those pre-product, but is an important accounting line item to understand. All equipment and machinery companies use wear out eventually. Depreciation and Amortization allow companies to match the revenue generated with the cost of using the equipment – making it so that the cost of the equipment is spread out over its lifetime, essentially “costing” it against revenues over time. This makes sense given not all revenues are recognized from a piece of equipment at once, so the cost is spread out over time as well.
Earnings Before Interest and Tax (EBIT): Simply EBITDA less Depreciation and Amortization and is less commonly used that EBITDA given depreciation and amortization have different calculation methodologies that can distort EBIT when comparing time periods or among peers.
Interest Expense: Companies that use debt financing will need to pay interest on their loans, and this is captured here. Interest income (from interest bearing investments, for example) is netted against this figure, but it is often an expense as the interest payments made on company debt are larger than any income.
This obviously is a more rare line item for earlier companies, but later stage companies will often mix debt with equity financing as debt financing has several advantages (both for founders in the lack of dilution and the company in terms of lower costs of capital). For companies that have debt on their balance sheet, the Interest Coverage Ratio (EBIT / Interest Expense) should be at least 1.20, meaning that for every dollar of interest to be paid, there is at least $1.20 of EBIT.
Earnings Before Tax (EBT): Also known as pre-tax profits, this is often the most commonly used profitability line item for VC valuations as most companies are operating with pre-tax losses and therefore do not pay taxes, and is – as you guessed- EBIT less interest expense.
Taxes: Companies that have positive EBT pay corporate taxes. For modeling, most companies deploy an average tax rate of 35-39% of EBT.
Net Profits: Finally, net income shows the accounting profit or loss. At this point, you should better understand why valuations are done using EBITDA or EBIT measures, as the differences across companies that come from D&A, Interest expense, and taxes create an apples to orange comparisons (especially considering US GAAP accounting practices versus international standards). Net Income is highly sensitive to these differences, and therefore gives a less pure look at how well run or comparable a company is when considering it’s revenues and the cost of those revenues – it’s daily operations.
Now let’s follow where these accounting profits (or losses) are stored on the balance sheet.
The Balance Sheet (The Current Snapshot)
The Balance Sheet is a snapshot of the company accounts – what it owns and what it owes, netting to the equity value of the company. The Balance Sheet can be reduced to the following fundamental accounting equation:
Assets = Liabilities + Equity and therefore, Equity = Assets – Liabilities
|Accounts Receivable||$3,317||Short Term Debt||$5,919|
|Total Current Assets||$12,005||Total Current Liabilities||$13,225|
|Property, Plant, Equipment||$8,493||Long Term Debt||$3,277|
|Goodwill||$4,246||Deferred Income Tax||$1,890|
|Long Term Investments||$7,777||Other Liabilities||$3,133|
|Other||$2,675||Total Long Term Liabilities||$8,300|
|Total Long Term Assets||$31,054|
|Total Assets||$43,059||Total Liabilities||$21,525|
|Paid in Capital||$7,378|
Assets: The assets represent what the company owns, and can be expected to be converted to cash at some point. Short term assets (or current assets) are those that will be converted to cash within a year, and long term assets are those that will be converted to cash in more than a year. Examples of current assets are things like inventory, accounts receivables (money that is owed to the company), land and machinery. Long term assets are typically things such as heavy machinery or factories. Note that when we say “convert to cash” we mean both in a literal sense (inventory) and indirectly (i.e. factories that produce goods and are therefore expensed over time via depreciation).
Liabilities: On the other side of the equation are the companies liabilities, or what it owes. These work the same way when considering short and long term. Short term, or current, liabilities include things such as accounts payable (payments due to the purchase of materials on credit), deferred revenues (revenue collected before services have been rendered. Examples of this include companies that pre-sell products – it’s not uncommon for those promises to go unfulfilled – making this a liability- and an important one to measure), upcoming salaries, and near-term loan payments due. Long term liabilities capture long term debt balances.
Equity: Company equity is simply the difference between assets and liabilities, and is often referred to as book value. The equity value is what we care most about when it comes to VC valuation and ownership.
When a company is incepted, it begins with a par value and a nominal amount of shares issued, generally $0.10 par value and 10M shares, creating a common stock value of $1,000,000. If the company wishes to raise an additional $10M from investors, it would do so and have additional Paid in Capital of $9M.
Adding to these values the amount of any net profits creates the equity value of the company. Therefore, as net profits grow or the company raises capital, it’s equity value grows. The equation above will always balance as, for example, net income grows, so does cash (an asset).
The Cash Flow Statement (What Really Matters)
For companies that are generating positive cash flows (see below), the cash flow statement becomes the most critical piece of accounting as it tracks the movement of real cash (not adjusted for accounting values like depreciation). It is possible, through accounting metrics, that companies can be generating tons of cash, but not show any profits (and vice versa!). This is why cash flows matter. There are three cash flow buckets to track:
|Cash Flows from Operations|
|Cash Flows from Investing|
|Other Investing Items||-$5,071|
|Cash Flows from Financing|
|Issuance (Retirement) of Debt||$0|
|Issuance (Retirement) of Stock||$1,569|
|Total Cash Flows|
|Net Change in Cash||$3,767|
Cash Flow From Operations (CFO): CFO starts with net profits and adds back the value of depreciation and amortization (a theoretical accounting expense, not an actual cash expense) to demonstrate the amount of cash generated from (or used) in the operations of the business.
Cash Flow from Investing (CFI): CFI captures the amount of cash used to invest in long term assets and R&D projects (and all the property, plant, and equipment necessary for purchase). Companies with very negative CFI are investing aggressively.
Cash Flow from Financing (CFF): CFF captures the cash flows used (paying down debts) or raised (borrowing or increasing debt) from financing activities. This cash flow measure will be rare for early stage companies and nonexistent for those companies that have not issued or raised financing or pay dividends.
The sum of CFO, CFI, and CFF will provide the net change in cash from the company over a given time period. For VCs, this will most often simply look like the cash raised from business operations plus any capital raised from investors less any amount of cash spent on things like R&D or large asset purchases.
Accounting for All of This
What are the key takeaways through all of this for VC due diligence? Having a strong understanding of how the three financial statements work together and being able to digest a company’s financial proformas is critical.
Knowing if the projections for revenues and the costs of those revenues and expenses seem reasonable together with projections for the sources and uses of cash can create a picture for the need for financing (and how much).