Often times, negotiations for a capital investment in a small business do not go in favor of the target.
Investors benefit, apart from their probable long-time experience in transactions, from the support of large consulting companies that have as main objectives to (a) identify to which extent the target is fit for investment and (b) to make sure that the transaction price is as low as possible without damaging the chances of closing the deal. The former of these is commonly used to justify a lower valuation, which is normal as part of negotiations, but that doesn’t mean that the seller should just accept the status quo, driven by the wish to fulfill their business objectives with the support of any newly added capital, if in different circumstances they could maximize their value.
First, the owners of the business need to clearly define their strategy when it comes to future transactions, including consideration given to capital dilution and inherently, its impact on control of the company. The key questions to be answered at this stage include:
- What’s the status of the company on its lifecycle? Is it pre-revenue and of not, what’s our ARR?
- What’s my current financial position and my bottom line? Is the company currently generating sufficient revenue to cover its expenses in a pessimistic scenario?
- What’s my business goal? Grow the company or count on an exit in the foreseeable future?
- What are my long-term objectives in terms of volume of business, revenue targets, growth, entering new markets, developing new products?
- Do I have a feasible plan to reach those objectives with the company’s own funds?
- What is my funding strategy: debt or capital?
- How much capital am I willing to give up to potential investors, or what’s the range of capital up for sale e.g. between 10-40%?
- How will the company look like in the eyes of experienced investors in terms of business viability, governance, internal control and systems?
Of course, these depend a lot on the type products or services that the company is selling and on the current shareholder and management structure. The key here is to make sure that we know everything about where the business is and where we want it to go. The more clarity shareholders have, the better their starting position in a transaction negotiation. And in a 1 to 1 lightsaber fight, everybody wants to have the high ground.
What’s also important is that the owners need to have this strategy laid out well in advance, to the extent that it is possible, as a financial due diligence looks for a period or around 3 years prior to the assessment date, and their engagement is focused on identifying the strengths and weaknesses of the company based on available information. While lack of such information only creates uncertainty and risk for investors, the opposite is likely to set up a very good position of the target before sitting down at the table.
Getting the company ready for a financial due diligence involves detailed preparations of the business strategy, products, markets, clients, vendors, but what is often overlooked is the basic accounting and other financial information that actually represents key data that investors are looking at to determine the potential and the value of the company. This financial information needs to be backed by an audit report (uncommon for start-ups or unregulated and private SMEs), or an effective internal control system that provides the investors with the confidence that the information is reliable. If investors decide they cannot rely on the financial information, this is more often than not a deal-breaker.
What does that mean in practice? Basically, it refers to three main categories of information: past, present, and future.
If an investor surprisingly approaches a company for an investment, this may create an issue, as small businesses may not be ready with their historical financial information. If you’re the owner of a small business that’s a target for investors, you should ask yourself if for the past 3 years (approximately, depending on set-up date, go-to-market date, key product launch date, etc.) you have recognized all revenue and costs to the company, you have recognized only revenue and costs related to the company, you have complied with all regulations related to transfer pricing and related parties transactions, all major contracts are substantiated by a concrete and delivered scope and ultimately if you can reliably demonstrate that there is sufficient control over financial information to ensure its correctness.
There are multiple ways that either separately or combined, can instill investor trust in financial information. From accounting policies and procedures (honestly and understandably, not common in the early stages of a company), to periodical management reports, analysis and monitoring of performance, some form of cost control, even spend controls on the company business cards – these all can support the fact that the company can and does manage its financials in an effective way.
Current performance is usually the baseline for defining the value of the company, while the potential for growth and added value is key for investors. What the most recent financial reports do is allow the investors to identify if your company is leveraged, what the equity level is, identify any liquidity issues – basically a health check of the business. To be prepared, make sure that you have all information at hand and analyze your financial KPI to be able to answer any of their questions.
Most of the times, this is the most important aspect of a financial due diligence if you’re at an early stage of developing your business. And because this is not actual data, you should expect a lot of scrutiny on behalf of the investors. If you don’t have one, you should prepare a business plan well in advance of the due diligence.
The business plan should be based on justifiable assumptions. That means that it should be grounded in your business strategy but taken to the next level of details. Related to revenue, you need to think in terms of markets, customer segments, marketing strategy and conversion rates for each of your key products and services. These translate into various KPI that are the foundation of your business plan, like revenue per customer, lifetime value of customers, and revenue per product based on your predicted pricing model. On the costs side, be sure to identify direct and indirect costs, variable costs and overhead in order to forecast these as accurately as you can based on the information at hand, while defining control mechanisms that will show investors that you are in control of the costs and that little to no unforeseen events may happen without management or board awareness and approval.
All these things contribute to creating a good picture of the company and its potential for investors. They increase the chances that the business will find the capital it needs to fuel its growth. But owners should not overlook that ultimately, these are all tools to help manage the business in a healthy way, even if their business is not the target of investors. On a day-to-day business, clear financial information (past, present, and future), backed by effective monitoring of operational KPI, has the objective of supporting the decision-making process, setting up targets for employees in line with the strategy of the company, mitigating financial risks, decreasing the level of uncertainty, and – of course – leading the company to a successful future.