What VCs really look for in your financial data
Before providing a funding offer or as a prerequisite prior to payment, venture capitalists will usually conduct due diligence to confirm the details provided by the startup are correct. Whilst most founders understand the broad outline of the due diligence, there are several areas where there is often confusion and misunderstanding which can derail the funding round.
Using inconsistent or incorrect financial metrics
FirstRate Data, a financial data provider, notes that the most common issue in the financial reporting for startups is inaccurate revenue recognition.
Founders without financial reporting experience will often categorise all incoming payments to the company as revenue, and use this ‘revenue’ number in all presentations and funding materials. However, the definition of revenue is much more restrictive than founders realise.
Startups which operate marketplace business models should have the value of the transactions on the network categorised as Gross Merchandise Value and not revenue. The revenue for this type of business is only the fee that the business charges on the transaction. This miscategorisation can lead founders to exaggerate the revenue by a very wide margin – often about 10 times.
Startups that operate SaaS business models which typically take payment in advance will need to understand the distinction between bookings and revenue. When a customer pays for a service in advance, this should initially only be categorised as a booking and later only realised as revenue when the service has been delivered. This is typically not a major issue for SaaS businesses targeting individuals and SMEs as the most common payment frequency is monthly which will not skew the booking versus revenue dramatically. However, enterprise customers will often pay annually which can lead to large discrepancies if the business is realising the full amount as revenue. Per QuantQuote, a corporate data provider, the average term of an enterprise payment schedule is approximately 11 months which can not only cause large revenue miscalculations but also mask churn as cancellations may not show up in revenue for many months.
Lack of internal controls
Startups typically initially operate with very crude internal controls, such as Excel sheets to track finances, a single bank (sometimes the founders personal account), and little in the way of formal processes (such as multiple director signoffs for large purchases). Whilst this can help the company be nimble and efficient in its very early stages, venture capitalists are trusting the company with a substantial investment and will need processes and procedures to protect their investment. At a minimum, the startup will need a dedicated accounting application for managing the finances which fully integrates with the billing system to generate automated real-time accounts, as well as formal procedures around payments and debt raising.
Intellectual property issues
Startups often fail to appreciate that its intellectual property (IP), which is the core value inherent in the company, is not owned by the company unless specific steps are taken. Employees and contractors will often have rights to their output such as customer lead lists, code, marketing materials etc. Thus, all IP needs to be fully assigned to the company in the employment contracts, service contracts with vendors, and company formation documentation (where the founders should assign any relevant IP to the company). Unfortunately, unlike the internal controls, the intellectual property can not always be rectified at a later date so it is essential to have this work done as early as possible.
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