Whether you are running a start-up or mature company, if you want to raise money from a venture capital or private equity firm, or borrow money from a bank or other lender, you are going to need a financial model. And by financial model, I don’t mean a single page spreadsheet with some rough numbers that comprise an income statement. I mean a financial model that includes all three financial statements, a multitude of accompanying ratios, analysis, and summaries, and very detailed assumptions that were used to generate the financial statements.
But why? Why is all of that detail necessary? Well, whether you are raising equity or trying to secure a loan, you need to tell the person a compelling story. You usually don’t start with the numbers, but rather with a summary or a presentation that will grab their attention and get their interest in continuing to review the opportunity. But then the story must continue in greater depth, and that is where the financial model comes into play.
The first chapter of the financial story is almost always the income statement. It’s the fun and optimistic part of the story. “In a land far, far away . . .” Equity investors and lenders will review revenue and EBITDA to determine if those numbers warrant spending any more time reviewing the opportunity. If they remain interested, they will continue their review by examining revenue growth rates and gross and EBITDA margins and trends. This chapter of the story is critical. Equity investors give a conditional thumbs up or definite thumbs down based on their review of the income statement. They want to see strong growth and EBITDA because they will benefit down the road from a multiple of that EBITDA when the company is sold. Lenders review the income statement to see if it is reasonable to think the company can support the repayment of their loans in the future.
The story continues in the second chapter with the introduction of the balance sheet. For lenders, the second chapter is the beginning of a love story that describes the protagonist (the assets) and the antagonist (the liabilities). Lenders review the balance sheet to determine what collateral they will have, how much they can lend against it, and what other liabilities are outstanding that will be competing with their loan for available cash flow. Equity investors are usually only interested in the balance sheet to gauge how asset intensive the business is and determine how much leverage they can put on the company.
The third chapter in the story is the cash flow statement. This chapter is a bit like poetry, the reader either sees beauty and deep meaning in it or doesn’t understand it at all. For those who understand the cash flow statement, they know it is the truth teller. Lenders will use it to determine the projected free cash flow that will be available to repay their loans. Equity investors will review the cash flow statement to determine when a company will become cash flow positive, how much more capital they will have to invest in the company in the future, or when they can expect to start receiving cash distributions from the company.
Like all good stories, there is a climax, which is revealed in the fourth chapter of the financial model, the analysis section. This section builds upon the financial statements by showing graphical representations of the numbers, trends, and summaries. It includes margin analysis, common size financial statements, various leverage ratios such as debt service coverage ratio and total debt to EBITDA multiples. It is a chapter that is simply putting on paper the math that good equity investors and lenders were already doing in their heads as they reviewed the financial statements. They have almost made their investing or lending decision by the end of the fourth chapter.
The final chapter in the story is the variables section. It is the resolution to the story that ties up all the loose ends and answers all the reader’s unanswered questions. It is the foundation upon which the rest of the story stands. Unfortunately, this chapter of the story is like a Russian novel. It can be very long and detailed and reveals the assumptions the management team used to build the projected financial statements. It is the resolution to the story that either makes the entire story believable and allows the investor or lender to make a favorable decision about the opportunity, or reveals that the assumptions aren’t sound, the foundation is weak, and the rest of the story just isn’t realistic. Like a good Russian novel, the character and thought processes of the management team are revealed in the variables section, and final judgment will be passed by investors and lenders based upon this section.
Now back to the initial questions, is the financial model important when raising money? The answer is an emphatic “Yes!” So who is going to build that financial model for you? Internal accountants and controllers should know your company’s numbers inside and out, but they usually don’t have much experience building financial models. CFOs, if you have one, might have the experience to build the model, but are usually most skilled at building financial models for internal use rather than external facing models for investors and lenders. If you don’t have the right person internally to build the type of model described in this article, you should consider hiring an investment banker or CFO consultant who brings a fresh set of eyes to the company, has built hundreds of financial models, and who has experience presenting and explaining those models to equity investors and lenders. The professionals at Waypoint Private Capital can help you build the right kind of financial model that tells the story about your company. We can also help companies with the rest of the capital raise process, including preparing the rest of the offering materials, introducing the opportunity to equity investors and lenders, negotiating the terms of the investment / loan, and closing the deal.
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