Investing in startups comes with substantial risks. While rapid revenue growth and impressive user traction numbers may grab headlines, they don’t always reflect the true financial situation of a startup. 9 out of 10 startups fail, and one of the main drivers is money mismanagement.[1] In this blog, learn more about evaluating startup financials and identifying red flags in a startup’s financials.

Evaluating Startup Financials

To make informed investment decisions, investors need to adequately assess all aspects of a startup’s core: team, product-market fit, traction, previous funding, and financial statements. In this blog, we’ll focus primarily on the financial statements and funding aspect of startups.

Overemphasizing Growth

A startup may attempt to dazzle investors with exponential revenue growth or rapidly expanding customer bases. However, growth without financial discipline could be a red flag for investors. When evaluating startup, consider the following pitfalls:

• Growth Fueled by Excessive Spending: Some startups may prioritize customer acquisition at all costs, leaving it susceptible to unsustainable burn rates. If a startup’s Customer Acquisition Cost (CAC) is greater than a customer’s Lifetime Value (LTV), investors may want to explore deeper.
• Revenue vs Profitability: It is possible for startups to be recording significant revenue numbers, but if profitability and operational costs do not align with the revenue the startup is bringing in, investors may want to ask additional questions to understand the why behind.
• One-Time vs. Recurring Revenue: A sudden spike in sales for a startup could be due to a single deal rather than long-term, sustainable demand

In order to adequately conduct due diligence on a startup, an investor should dig into the startup’s income statement, balance sheet, and cash flow statement in order to understand a holistic view of the startup’s health.

Future Projections

It can be easy for startups to overemphasize existing growth and potential future growth. While Serviceable Obtainable Market (SOM), Serviceable Addressable Market (SAM), and Total Addressable Market (TAM) are common metrics shared in pitch decks, investors should consider taking these estimates with a grain of salt. At the end of the day, these metrics measuring the portion of the market a startup can capture, the portion of the market a startup realistically expects to capture, and the total market for a startup’s products do not typically accurately reflect the true future traction a startup will actually capture.

In order to avoid placing too much emphasis on future projections, investors may want to take a look at existing traction in order to get a better idea of what future growth and timelines may look like.

Declining Gross Margins

Gross margin, or the difference between revenue and the cost of goods sold (COGS), is considered to be a fundamental measure of a startup’s efficiency. A healthy margin may suggest that the startup will be able to scale profitably, while decreasing margins may indicate rising costs, pricing pressure, or operational inefficiencies.

Investors should consider comparing margins over multiple quarters – are they stable? Increasing? Decreasing? Taking a broader view of gross margins may provide some indicators into the startup’s health.

Unsustainable CAC

Acquiring customers is one of the most important things for startups, as they wouldn’t be able to operate without someone purchasing their products/services. However, if the cost to acquire a new customer outweighs a customer’s long-term value, this may be a red flag. Some startups may fall into the trap of spending aggressively on marketing without focusing on customer retention or monetization.

To evaluate CACs further, a useful metric may be the LTV/CAC ratio, which compares a customer’s lifetime value to the cost of originally acquiring the customer. A ratio of 3:1 or higher is generally considered to be a healthy ratio, while if the number is closer to or below 1:1, that may mean the startup is losing money on each additional customer.

Unsustainable Burn Rates

While a negative cash flow may be common for early-stage startups, if a company is burning cash faster than it is growing, this may be a red flag for investors. A startup’s cash runway, the amount of time before a startup runs out of cash, is an important metric to consider. A short runway with no clear path to additional funding or achieving profitability may indicate poor startup health.

Review a startup’s cash flow statement to see where the money is being spent. Ask questions about upcoming financial obligations, and ask about contingency plans if fundraising becomes difficult before profitability can be achieved.

Debt and Unfavorable Financing

While many startups use debt as a tool for growth, excessive debt at unfavorable terms can be a red flag in a startup. High-interest loans or convertible notes with aggressive conversion caps may erode investor trust and strain operations.

Consider examining the balance sheet for debt-to-equity ratios, take the time to understand the terms for any loans or convertible financing, and assess whether or not the startup can realistically pay back the debt when deadlines loom.

Overdependency

If a startup relies too heavily on a single customer for revenue or a supplier for operations, this may indicate potential risk. If that customer decides to go with a competitor or if the supplier decides to raise prices due to market conditions, a startup’s financial health may not be what it seems.

Assess how well a startup’s customer base and supplier contracts are diversified. Ask questions about long-term contracts and partnerships, and evaluate contingency plans for potential  supply chain disruptions.

Final Thoughts

While no company is perfect, recognizing red flags in a startup’s financials may help investors conduct thorough due diligence before making investment decisions. The importance of due diligence cannot be overstated, and investors should take the time to inform themselves on other aspects of a startup as well, like the team’s suitability, the industry and competitors, and other factors. By taking a disciplined approach to due diligence, investors may be able to make investment decisions that better align with their long term portfolio goals.

Are you ready to invest in startups? Sign up for a MicroVentures account to start investing!

Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Navigating the Risks: Why Startups Fail
• Failing Forward: What Investors Can Learn from Failed Startups
• Risk and Reward: Building Your Ideal Portfolio
• How to Start Investing in Startups

 

[1] https://hbr.org/2021/05/why-start-ups-fail

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.