One of the most useful skills as an entrepreneur is number crunching. If there is one thing about numbers that I’ve learned over the years, it is that I can make them sing whatever song I deem fit. Numbers are like rules – they are meant to be pushed.
For example: My blog gets a few thousand unique visitors a month. Not bad for a niche business blog, but I’m certainly not going to feed my family by blogging (nor would I want to – how boring). My blog is a fun, yet professional diversion, but lets face it, the traffic is relatively low.
However, did you know that statistically speaking, this blog is currently ranked in the top 1% of all of the blogs on the Internet according to Technorati? Yep!
Of course, my actual ranking is around #39,000 (at the time of this writing). But, since Technorati tracks over 51.5M blogs, that puts me squarely in the top 1%! But “Top 1%” sounds a heck of a lot better than “#39,000” :)
One of the things that entrepreneurs have to master is the art of spinning numbers.
Typically, when approaching an investor, you’ll hand them a 1 or 2 page executive summary of your idea or business. The believability of that document will hopefully lead you to the next step, which usually involves a 20-30 minute “pitch” of your idea or business. Hopefully, of course, you will continue down the path of capital glory by entering due diligence, and reaching a climactic ending with a term sheet. However, it all starts with that 1 or 2 pager.
I recently handed our one page executive summary to a potential investor. This person commented that our financial projections were “probably unachievable. ” I looked him in the eye and asked him what numbers he’d like to see instead? He was caught by surprise a bit. He told me that “numbers didn’t work that way – that there had to be a model behind it.” Of course, there was a model behind those numbers – they just didn’t add up to something he liked, or something he thought was sane.
I told him that I could make the numbers look like whatever he wanted to see. “Hell, I’ll even give you an inch-thick spreadsheet model that justifies those new numbers. It doesn’t matter at the end of the day – neither one of us knows how this business will ultimately perform. What do you want to see for revenues on this one pager? I can promise you that I can not only show those numbers, but I can defend them. So what will it take to end this silly charade so we can get to talking about my venture?” :D
The next day, I handed that same document to another investor. This person thought those same numbers were very conservative, and probably undervalued the company, given the market we are in, and our approach to addressing it.
Welcome to the world of subjectivity.
At the end of the day, it is a complete toss-up, as every investor is going to have their own pet peeves about your numbers. However, here are a few basic tips for you, or at a minimum, some things to keep in mind:
1. Close the gap: If your top line revenue after 4 years is $50M, and your operating expenses are $2M, this is going to be a red flag. That would be an EBIT of over 90%, which would make you the most brilliant businessperson to ever grace humankind. This tells the investor that either you are grossly overestimating your revenues, or wholly underestimating your expenses. Take a hard look at the assumptions in your model. You need to close this gap. You also have to keep in mind that investors are most likely going to apply the “rule of twos” to your model. They will divide your revenue projects in half, and double your expenses. Use this knowledge to your advantage and create a set of financial projections that takes this into account.
2. Don’t climb the mountain in one giant leap. If your 3, 4, or 5 year projections looks like a ridiculous hockey stick, give some thought to how you can flatten out the curve a bit. There are very few businesses that are going to hit $100M in 3 or 4 years. No offense, but chances are, yours isn’t one of them. Investors expect to see growth year over year, but they don’t expect you to have a near-vertical ascent! Whatever model you decide upon, you can bet on one thing: investors are going to challenge your assumptions behind that model. Be prepared to defend them!
3. Don’t forget about the human capital factor (headcount). If your projections call for a 10 person company to be responsible for generating $50M in revenue, this is going to be a red flag. This will tell the investors that (again) you are either overestimating your revenues, or you are underestimating the level of effort that will go into it. Take a look at your revenue per FTE (full time equivalent). Take your revenue number for a given year and divide it by the number of employees you will have during that year. That is your revenue per FTE.
The following info is from a 2005 study done by SHRM (Society for Human Resource Management):
Revenue and net income are strategic financial indicators of performance for most organizations. When total revenue is divided by total employees (FTEs), the resulting number is a marker of efficiency.
This ratio, termed revenue per FTE, conceptually links the time and effort associated with the firm’s human capital to its revenue output. To illustrate, for an organization that has $100 million in revenues and 300 employees (FTEs), the calculation yields a ratio of $333,333 per FTE. If the revenue-per-FTE ratio increases, it indicates that there is greater efficiency and productivity because more output is being produced per FTE. If the ratio decreases, it indicates there is less efficiency and productivity.
The following chart also appears in the study. This shows you what the industry averages are. Of course, this data was taken from more established companies (i.e. they had an HR director on their staff), but it should give you a feel for where established companies are regarding this particular metric. Click the thumbnail to view the larger image.
If you want to see the full report, click here. It is a very interesting read. Also be sure to consider your expenses-per-FTE as well (although this is not nearly as important as the revenue per FTE, IMHO.)
My message in all of this is simple. Whatever numbers you give to an investor upfront will go a long way toward determining whether or not they want to continue to have a dialog with you. If they are too high, your head is in the clouds. If they are too low, then there is no real business there. This is a delicate balancing act. Put together a working business/financial model for your venture, and then apply some of these simple metrics to it to see where you stand. Your potential investors will also be applying these metrics in their head, so keep that in mind.
Enough rambling from me. Go change the world.
If you have your own thoughts around financial metrics, and presenting them to potential investors, I welcome you to add them via a comment below. Comments are moderated, so unless you’ve commented on this blog before, I have to approve them – FYI.