Module 4: Reviewing the Data Room & Analyzing Financial Statements

What to look for in everything from a balance sheet to a convertible note ledger and operating agreements.

By The Helm

Okay, so you’ve met the founder, reviewed the pitch deck, and you’re excited about the investment opportunity. What’s next? At this point in the process, The Helm would request access to a data room and begin analyzing financial statements. This can be intimidating for many so let’s break it down. (If you would like a refresher on our earlier modules, please review one, two, and three.)

What’s in the data room & what to look for

  • Capitalization table: Known colloquially as the Cap Table, this spreadsheet breaks down the equity ownership of the company. Here are a few things we look for:
    • How do the founders split equity? It doesn’t need to be equal, but we want to make sure all executives are compensated thoughtfully based on their contribution
    • Are they properly incentivized? Early-stage funding rounds typically give up 20 percent of the company i.e. raising $1M at a $5M valuation. As founders raise subsequent financing rounds, their ownership will decrease. If they have a small stake at the seed stage (which will continue to get smaller each time they fundraise), will they continue to be incentivized if and when things get tough?
    • Are there other major shareholders (>10%)? You’ll want to know who has influence and decision-making power. 
    • Any notable, experienced investors? For example, if you’re investing in a marketplace and Jeff Bezos is also invested, that might be a good sign. Angels usually invest before investment funds get on the cap table, but there might be a high signal name that could add strategic value. 
    • Do they have an ESOP (Employee Stock Option Plan) reserved for future employees? 10% is a good benchmark. Assuming the company grows, early employees will likely be lured to join through a compensation package that includes equity. If this is not accounted for, the equity will have to come out of the founders’ shares. We like to see founders that are forward-thinking enough to account for this upfront. 
  • Convertible note ledger: Many early-stage companies are funded through convertible notes (as opposed to equity) so they will not show up on the cap table until the notes convert to equity. The convertible note ledger includes all the investors that will be on the cap table after their notes convert to equity. This is called “full dilution”. 
    • Do they have outstanding convertible notes that are converting to equity as part of this round? This is completely normal, but will decrease the amount of ownership you (and the founders) have once the notes convert. Ask for a fully diluted cap table (assuming all notes convert) or copies of the previous convertible notes to get a comprehensive picture. For a refresher on convertible notes, see module two
  • Profit & loss statement: Also known as P&L or income statement, this financial statement summarizes revenue and expenses over a time period. Later stage companies have a CFO or accountant put together an annual income statement, but at the early stages of a business, a company will typically have a simple quickbooks printout. We want to know how founders are spending their capital and whether they are doing it efficiently. Typically, we are looking for a month-to-month excel spreadsheet showing expenses (and revenue if applicable) for the last 12-36 months. 
    • Look at the gross, operating, and net margins to see if they are in line with industry averages. 
    • What is their monthly revenue (if any)? Is it contractually recurring or variable? Are there any trends?
    • What are their monthly operating expenses? Are they efficient with their capital? How expensive is it for them to run the business without any revenue? Are there CapEx needs (real estate, equipment)? Are salaries of executives reasonable? Generally, we look for a salary that is below market, but allows a founder to commit full-time. At the early stages, we typically see $60,000 – $130,000 depending on geographic location, expertise, and a variety of other factors. If the company is close to breakeven or profitable, they have a lot more room to pay themselves more.
    • What is their monthly cash burn? How many month’s runway will they have based on their cash burn? The burn rate is typically used to describe the rate at which a new company is spending its venture capital to finance overhead before generating positive cash flow from operations. Runway refers to how many months your business can keep operating before it runs out of money. For example, if revenue is $20,000 and expenses are $50,000 per month, cash burn is -$30,000. If the company raises $300,000, they can cover 10 months of runway ($30,000 x 10 months). We typically like to see companies have enough cash to cover 12-18 months before they have to fundraise again. If it is less than that, the founder is going to be constantly distracted with fundraising versus operating.
    • Calculate individual expenses as a % of total OpEx. Are there any red flags? Salaries and rent are typically large, but if advertising, insurance, or travel were also 50 percent of total expenses, I might ask what is driving that. For a CPG company, check out inventory turnover. 
  • Financial projections: This is a spreadsheet with assumptions on the financial growth of the company over the next 12-60 months. Typically we like to see month-by-month projections over the next 3 years as a testament to the granularity of the founders’ thinking, but it is not unusual for a founder to just have annual projections over 3-5 years. It is okay for a founder to pay a third party to build the financial model, but we want the founder to understand the assumptions made and the milestones needed to achieve them.
    • What growth assumptions are they making? We love to see the actual calculation versus hard-coded numbers. For example, if it’s 50 percent growth month-over-month, is that reasonable? Is there historical precedent? Or if they have historic sales of $10,000 per month, will they be able to achieve projections of $100,000 per month? If so, what is the impetus for that growth?
    • What is the projected cash burn? Is it higher than the historical cash burn noted above? Are expenses increasing or decreasing as a percentage of revenue? Typically, software companies see expenses decrease as they start to scale, but industries with high amounts of research and development (R&D) might see expenses increasing. Bonus points for scenario analysis (having projections for a base case, worse case, and best-case scenario).
  • Balance sheet: This financial statement is a snapshot of a moment in time, so make sure it is current (within the last 30 days). This statement is called “balance” because we think of it like a see-saw. A company’s assets equal its liabilities plus equity. 
    • How much cash do they currently have?
    • Do they have any fixed assets? IP?
    • Any outstanding debt? If so, always ask to review the debt documents. Will your investment be used to pay down debt? There are always exceptions to the rule, but in general, you want your investment to go towards moving the business forward versus repaying old debts. 
    • Are there loans from the founder? Are they properly documented and do they have reasonable payback terms (interest and time)? What founders and owners call loans, VCs typically call sweat equity.
  • Bank statements: We typically review the last two months’ detailed bank statements with transaction history.
    • Verify cash balance and understand actual cash burn by looking at the beginning and ending balances. Does cash burn match the financial model?
    • Any notable expenses or red flags? Some red flags we’ve seen: excessive travel or entertainment expenses, Venmo’ing employees or themselves.

Other non-financial items in a data room

  • Articles of Incorporation & Operating Agreement
    • How and when did the company legally form? VCs typically invest in C-Corps, but it is easy to convert from an LLC to a C-Corp. 
    • Are any founders no longer with the company? If so, ask why. If they still have meaningful equity, can the existing founders buy them out so they no longer have meaningful decision-making power? 
    • How do founders split their duties? Learning how founders split duties allows you to get to know them better, gain insight into their strengths—and what kind of leaders they will be. This insight could show you how conflicts of interest might arise so you can prepare for them. Remember, 65% of startups fail because of founder conflict.  
  • Customer list & pipeline (B2B)
    • Is revenue contractually occurring? Are they paid or unpaid pilots? Paid is preferred as there might not be the same customer buy-in if they are getting the product or service for free. Watch out for partners versus customers. Partners typically get the product for free or for quid pro quo whereas customers sign a contract.
    • What is the average contract value and length? Multi-year contracts are ideal.
    • Who is the internal decision-maker at the company? You want to see that the internal champion has purchasing power which is usually associated with revenue-generating departments (ie selling into HR is historically tough since it is a cost center).
    • What is the current stage of conversation? What is the probability of closing? What is the expected close date? What is the expected revenue amount?
  • User metrics (B2C)
    • Ask for the number of daily active users (DAU) or monthly active users (MAU)? How engaged are their users? What are the trends for growth or churn?
    • For consumer companies, how much they are paying to acquire users (CAC) is the most important metric. Likewise, ask for the customer lifetime value (LTV)? What is the LTV/ CAC ratio? A good benchmark for LTV/CAC is 3:1. 
    • Learn about more metrics to look for: A16Z: 16 Startup Metrics and 16 More 

If this seems like a lot, that’s okay! It can be overwhelming at the beginning but, like anything, it becomes easier and more familiar with time. In summary, here are the top things we look for:

  • Fairly compensated and incentivized founders
  • Capital efficiency (reasonable expenses and runway for 12-18 months)
  • Paid and/or engaged users
  • Low amounts of outstanding debt with appropriate payback terms
  • Understanding of financial growth assumptions & the milestones needed to hit them 

Up next in Module 5, we’ll deep dive into term sheets.

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