Bill Petty
Are you a founder looking to raise capital? If so, before you open the door to potential investors, your financial house might need a little spring cleaning.
As a growth equity investor, we meet with many founders who have a solid handle on the day-to-day operations of their business and have some of the basic financial “pillars” in place. They have a basic accounting system, know how to construct a budget and have policies and procedures for accounts receivable and accounts payable.
This is a great start, but investors usually bring a different level of scrutiny to your operations and financials, and they have a much higher expectation for what “good” or “great” looks like.
It’s the difference between inviting a friend over for dinner and preparing for an open house. With a friend, you might tidy up and shove a few things in the closet. If you have buyers coming to look around, they’re going to open that closet.
It pays to be ready.
What investors want to know
During due diligence, every investor is looking for an accurate view of your business performance, value and potential. They build that picture through a series of data and information requests to try and answer these important questions:
- How is your historical business performance?
- How are you thinking about and planning for growth?
- What is the ownership breakdown?
- Who are your key clients and what is the nature of the work you are completing for them?
- How are you managing the business? What is your attrition, utilization, bill rates, etc.?
- Are there any outstanding tax risks?
The details of every diligence process look different, but you can count on one thing: Having a plan is key. It takes effort and hours to gather, verify and package all this information for external review, so it helps to know what data and documents will be needed well before you enter the process. Otherwise, it can be a real distraction to the business.
Let’s take a closer look at each of the six standard information requests, and what investors are really looking for when they deep-dive into your data.
Annual and monthly financial statements
Financial statements provide an overall view of the health of the business, and a high-level year-by-year and month-by-month snapshot of growth.
If you have a financial leader in the business or a good accountant, preparing financial statements may be one of the easiest information requests. While every investor has different requirements, the last 24 months of financials are typically enough for early-stage diligence. At later stages, investors will likely ask for a longer historical view and may involve a third-party accounting firm to help verify accuracy.
Investors are looking closely for revenue, revenue growth, gross margins and profits while assessing trends and, at the same time, anomalies. Founders need to understand and be familiar with this data, as investors will likely probe in a number of areas.
Beyond understanding the data, investors will also want to know whether your revenue and costs are calculated using GAAP (generally accepted accounting principles) or another accounting standard (e.g., cash basis).
Financial projections
Investors use financial projections to understand many key elements of your business, but there are two crucial use cases.
First, do the assumption inputs align with the key operational metrics of your business? Investors care just as much about how you think about and model growth as much as the projections themselves. For example, in a services business, there is a direct correlation between delivery employees and revenue. Therefore, delivery employees should be a key input — or at a minimum, a key consideration — for your projections.
Second, how do your projections align with the future growth of the business? Investors will use your projections as a starting point to evaluate future growth, which is one of the most important considerations for investors. In terms of the projection period, investors usually require a one-year projection and “want” a three-year projection.
Quick caveat: Founders are sometimes tempted to be overly optimistic about future growth. If your projected growth diverges materially from recent historical growth, be armed with a rock-solid explanation for why it is so.
Detailed capitalization table and options schedule
Investors need to know exactly who owns what, how much and when. A cap table and an options schedule provides this granular detail. Both are necessary for investors to understand who has an economic interest in your company, determine if an option pool will need to be created or expanded and calculate their fully diluted ownership after the investment.
Cap tables are one of the most important documents your company should maintain. If you don’t have one, create one now.
It can be as simple as building one in Excel, but the reality is, cap tables can become complicated quickly. It’s also essential they’re free of errors. I recommend using cap table software like Carta to make your life easy and ensure accuracy.
If you are thinking of raising capital or creating an option pool, enlisting the help of a lawyer would be a good idea. Here is some excellent advice regarding option pools.
Revenue by client and revenue mix
Looking at both revenue by client and revenue mix helps an investor understand the “who” and “how” behind your customers and revenue.
The “who” piece tells investors who your clients are, how many clients you have and how much of your revenue comes from your top X clients. It also gives investors valuable insight into whether you are serving SMB, enterprise or large enterprise clients and whether those clients are more B2B or B2C in nature.
Further, investors want to understand if most of your revenue comes from clients you have been working with year after year (recurring revenue) or whether there is significant turnover in your top client base every year.
The revenue mix detail answers “how’ you are billing your clients. Are you delivering consulting and implementation services through a professional services time and material model? Are you delivering services under a fixed-fee engagement model? Are you reselling licenses and delivering services? These are all common revenue models in IT services, and investors want to understand how your revenue is generated and billed.
Creating a breakdown of your clients shouldn’t be a major lift if you have a CRM system and good processes in place, but your revenue mix may take more time to aggregate and present. This information is sometimes tracked across multiple systems, and the way you choose to report it can vary, but it’s one of the most important pieces an investor will look at.
Operational metrics
At a high level, the most common metrics that IT services investors are interested in are: bookings, backlog, utilization, pipeline, headcount, employee attrition, revenue per employee, bill rate and customer satisfaction. SaaS investors will want to see annual recurring revenue (ARR), customer lifetime value (CLTV), customer acquisition cost (CAC) and product usage data.
The metrics central to operational success varies by business, so it helps to ask around what investors in your space will consider most important, and begin tracking those metrics if you aren’t already.
Keep in mind that many of these operational metrics are interconnected with your financial plans and projections. A red flag, for example, would be if financial projections indicate 100% growth in the coming year, but there is minimal pipeline, backlog or recurring revenue.
Tax information
Tax liability exposure can be a concern for investors, especially if a company they are investing in is of a certain size and exposure that could cost large sums of money down the road. This is why corporate tax returns and other specific tax documents will be requested at some point during the diligence process.
Don’t be surprised if investors hire an outside accounting firm to review your federal, state and foreign tax filings, and sales and use tax filings. With post-investment in mind, they will also likely review the company’s organizational structure to determine how the company will be treated for federal, state, local and foreign tax purposes going forward.
Get trusted support
Juggling all the tasks to get these details can get overwhelming, so preparation is key. Even if funding may not be in the immediate future, start thinking about how you want to organize and prepare your financial house for future visitors.
Having the right internal team or advisers can make the preparation easier. A trusted team member or consultant is an invaluable resource for founders who still need to focus on their day job (running and guiding the business). You don’t have to go it alone.
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