"Love Thy Accountant"
Updated: Jul 4, 2020
Choose and engage your consultants wisely
So, you are raising money. Good!
Let us focus on investors' perspective for a moment.
In many ways, you are offering them promises of future fortune, for which they will depart from large sums of cash, now!
Investors need to accept your premises about the market, unmet needs, the opportunity, and how are you going to answer it - better than your existing and presumed competition.
How are you going to convince them?
The World and you:
Usually entrepreneurs build models depicting the world: Accessible and serviceable market size, competitive landscape and access strategies. What entities are buying, who takes decisions, when do they disburse money.
On the other hand, they also model internal activities: Recruiting managers and developers, building prototypes, running PoCs and eventually - launching their product, pushing it to the market.
I believe you, but I wanna be sure:
The challenge entrepreneurs face - approaching investors - is the information gap between them (having studied the problem space in much detail) and investors, who come from different background.
Even strategic investors don't always know what you know about the exact need (although they often do). So there is a need to convey these data credibly.
What's more: Can investors trust entrepreneurs' representations - them being intrinsically optimistic? Nor can they know for sure what is the status of the venture. What threats lie dormant?
Term sheets and valuation
This discussion pertains to the happy scenario, in which prospectives would invest in your firm. A question looms - at what valuation? Sure - you have set your goals, but rest assured, they know their Maths, otherwise they would have not been investing.
Whatever method used, investors will use variants of DCF - Discounted Cash Flow. In so many words, it sums the stream of proceeds projected from your venture, discounted to a present value.
The discount rate represent the time cost of money and the perceived risk of your venture. The lower the discount, the higher the valuation.
The term sheet is a relatively concise document, delineating the terms and conditions of the investment, including the valuation. Once signed, a process of due diligence ensues, in which the investors find everything (bad) they can about your business.
Would the valuation go UP, should the due diligence find nothing terrible? I guess not. Can it go down? Somewhat - this could be a deal breaker.
So what to do? My answer to this is that the discount rate factors in also unknowns that might be found during the due diligence process.
Perceived risk ( r ) and DCF - the expected discount flow (the valuation) are inversely correlated. The more "unknowns unknowns" lurk in your representations the higher the risk, the lower the valuation.
Enter Accountants, Lawyers
Here lies the value of your precious advisors. Helping entrepreneurs to properly prepare an investor presentation - backed up by a dossier, they can iron out many uncertainties for new investors:
- Who owns the company? Are there hidden founders, disgruntled employees lying low for an opportunity?
- Who owns the IP? Is there any IP at all? Do you have FTO (Freedom To Operate) on it? Do you owe future royalties that would reduce investors value?
- Are your forecasts real? How do they compare?
Answering these questions beforehand increase trust, reduces risk perception, and therefore reduces the (subjective) risk score and resulting discount rate, thus increasing potential valuation.
Who says what
It is one thing if entrepreneurs submit a presentation / dossier for investors to inspect, and another if this is mediated by a trusted 3rd party. Consulting firms, advisors, have their reputation to protect, so any factual representations would be double checked.
Gravitas is not the only value advisors provide. Form is key when representing or evaluating risky business - this is a good way to compare apples to apples.
So, is it worth it?
Accounting firms, corporate lawyers are not known to be cheap. However, they do want to earn your (potentially - explosively) growing business. Guess what: Even in the eventuality of your venture going South, they will have work to do, and fees to collect.
Make sure you are covered - What are the services you buy with your annual fee, and what concessions can you obtain either in hourly rates or in deferred payments.
What is your intuition about potential gains for startups? Is this just a premium, nice-to-have, service, or does your investment pays off, in successful rounds, in shorter rounds, in higher valuations?...
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