Welcome to Startup Investing: Forget everything you’ve learned about financial metrics (Part 1)

New to startup investing? So am I. 

A few months ago, I jumped ship from the audit practice of a Big 4 accounting firm to join an innovative, entrepreneurial, striving venture capital firm. I knew it would be night and day, notably because startups financials have little in common with large corporations and that accounting principles often clash with startups economics.I always go back to Ben Horowitz writing with bitterness, “I still hate Ernst & Young” in “The Hard Thing About Hard Things”. If you’re not familiar with Ben’s story — his company was forced by its auditors to change the revenue recognition on three large deals from upfront recognition to recognizing it rateably over the life of the contract in the middle of M&A negotiations. This reduced their quarterly results drastically and made the bidders pull out.

These situations aren’t uncommon because the startup financial model is very distinctive of “traditional businesses’.” When I first started working on deals at Brightspark, it felt like everything I’d learned about financial analysis and valuation was wrong. I wasn’t — sometimes still am not — asking the right questions.

And I’m not alone – even some veteran financial investors that are new to venture capital don’t focus on the right financial information when it comes to making investment decisions. And that’s normal. After all, we’ve been taught in our financial training to judge a company’s performance based on revenue and earnings per share. While this is accurate for the majority of publicly traded companies, it’s not the case for early stage companies.

To help newcomers to the startup investing world, I decided to compare some metrics frequently used by financial analysts to the elements that really matter when investing in early-stage companies

Cash Flow

Most investors will agree that the Cash Flow Statements is the most important financial statements of all. For most businesses, the very first financial health check-up is to validate that the cash flow from operations - the cash generated by the company's core business activities - is positive. There is a good chance that companies not generating cash from their main operations will eventually fail.

In our world, because we invest in companies so early in their development cycle, we look at the company’s burn rate instead. Burn rate is the amount of money a company is either spending (gross) or losing (net) per month. In the early stages of a venture’s life, it’s totally normal for the management to spend more cash that the business generates. What we care about is that the management is not spending too much money, and that the money is being spent on the right things. Finally, cash shortage drives most startups to fail. Cash in hands divided by monthly burn rate indicates how many months the startups can go on before needing additional financing.  A good rule of thumb when considering an investment in a startup is to ensure that the company has at least 12 to 18 months of cash ahead so management can focus on building the company and not only on funding its operations.

Startup investors shouldn’t get spooked by the fact that a startup is not generating positive cash flow yet. However, we ALWAYS check that the team is smart about how they spend their money and that they will have enough cash on hand to reach their next funding milestone.

Sales Growth

Sales is usually the most straightforward part of the income statement for any businesses. Mature corporations are seeking an on-budget, consistent, sustainable revenue growth. To give you an idea, the mean annual sales growth of Standard & Poor’s 500 is around 3%.

Venture capitalists would not invest in an early-stage company targeting an annual sales growth of 3%. Instead, for whatever growth metric used (revenue, customers, users, etc.), we’re looking for Hockey Stick growth. The Hockey Stick growth indicates that business grows at a regular, linear pace until the company hits an inflection point, and growth takes off at an exponential rate. If an early-stage company doesn’t project to hit exponential growth in the next few years, it is probably not a fundable VC business since the potential upside doesn’t justify the risk.

As VC investors, we do not panic if a company misses its revenue targets on a certain month or if growth takes a bit longer than we thought. We focus on the end-game. What matters the most is that the founders are heading for that Hockey Stick growth.

Continue reading - Part 2 here.