To what degree, if any, an early-stage investor should care about financial projections when conducting diligence on a startup? Investors often have polar opposite opinions on financials: some insist that detailed, multi-year projections are a necessity; others that financials are wild-guesses and a waste of time – both for entrepreneurs to prepare and for investors to read.
Investors that believe in financials usually are some combination of (i) business or financial professionals accustomed to working in large organizations or investing in later-stage private equity or project finance deals; (ii) people who were active in early-stage investments in the early part of the last decade when it took millions of dollars merely to get a company to the prototype stage; or (iii) investors active in industries like clean-tech and bio-tech where startups have large upfront capital needs.
Investors that care less, or not at all, about financials frequently are people used to consumer software/web application companies that can get off the ground either through bootstrapping by the founders or a small amount of outside investment.
The nature of the financial due diligence you should conduct depends on the context of deal and likely falls somewhere between those two poles.
On one hand, if you are contemplating a small investment in a software company that already has a prototype and is looking for a few hundred thousand to accelerate sales and marketing, it’s probably a waste of time to ask for or review detailed financials. You should, of course, ask the company about their market size estimates and their sales strategy, but requesting an estimate of their expenses 39 months into the future is silly. There is no way that the company can know that figure and they would be better off spending the time it would take to guess talking to customers. In this situation, a more appropriate level of financial due diligence may be market estimates combined with a one-year revenue/expense projection. Even though the latter is almost guaranteed to be an upward sloping curve, looking at the numbers will give you a sense of how realistic the company is being about their growth.
On the other hand, if you’re looking at a large investment in a company proposing to build a multi-million dollar factory to produce a new type of battery you probably want a extensive, 3-5 year financial model. The truth is that any company asking for this type of investment should already have the model prepared and be able to provide it on demand. Inability to do so is a red flag. Once you receive such a model be sure to ask for help interpreting it – in particular, ask the company to walk you through their assumptions behind the projections.
These examples are extremes but consider the issue of startup financials along a sliding scale. Factors to consider include: (i) your potential investment size; (ii) total size of the round; (iii) other investors in the round; (iv) industry; (v) experience of the executive team; and (vi) stage of the company.