When choosing to invest in a startup, it can be a challenge to understand the business’s potential growth trajectory with limited historical financial statements. For pre-revenue companies, they may only have projected financials. In this blog, we will cover early-stage companies’ financial statements, how to read them, and how to evaluate projected financials.
Understanding Historical Financials
Financial statements are one of the most highly scrutinized aspects of a company’s offering information. Typically, the intent behind investing is to at least recoup the original investment amount, if not gain an additional return. While this outcome is never guaranteed, financials are often considered a key factor considered when evaluating a startup investment opportunity.
Components of Historical Financials
Historical financials are most commonly comprised of a balance sheet, a statement of operations (the breakdown of the income and expenses), and a cash flow statement.
The balance sheet is a financial statement that provides a breakdown of the company’s assets, liabilities, and shareholder equity at a specific point in time. The most basic equation for the balance sheet is assets = liabilities + shareholders’ equity. The name “balance sheet” comes from the two sides of the equation being balanced, or equal to each other. This financial statement can help investors see an overview of the state of the company’s financial wellbeing and are typically prepared on a monthly, quarterly, and annual basis.
The statement of operations serves as a current view of where the company stands in relation to its operations and current financial standing. This provides a clear view of the income and expenses the company incurs. Statements of operations are also commonly known as Profit and Loss Statements (P&L, P/L), a statement of income, or a statement of earnings.
The income and expenses aspect of the statement of operations provides a basic annual breakdown of gross revenue and cost of goods sold. “Gross revenue” is considered the total revenue produced from selling the company’s product or service. “Cost of goods sold”, is the total amount of capital spent on producing the product/service. This is also known as a “variable” expense because the total amount will vary month to month based on production. Deducting cost of goods sold from gross revenue wields the gross profit if the number is positive, or gross loss if the value is negative.
Operating expenses are all other costs associated with running the company besides directly producing the product or service. Administrative fees, employee wages and salaries, and rent are all examples of operating expenses. Also known as “fixed” expenses because they are not expected to significantly vary from month to month, operating expenses are generally easier to predict in advance than variable expenses.
Deducting operating expenses from the gross profit or loss produces the operating profit if the number is positive, or the operating loss if the value is negative. Once interest and income taxes are deducted from the operating profit/loss, the final resulting value is considered the “net income” or “net loss”. The value will tell you if the company made or lost money that year. It is important to note that it can take up to an average of 3-4 years for a company to become profitable, if at all.
Another piece of historical financials is the cash flow statement. This breaks down the cash and cash equivalents that that enter and leave the company. However, it also includes depreciation expenses and does not include non-cash transactions, which is how it differs from the other financial statements. The main components of the cash flow statement are operating activities, investing activities, and financing activities. Providing a trail for where the capital comes from and where it gets spent, can provide a glimpse of the company’s financial footing.
So, when companies can take years to become profitable, what can an investor use to evaluate the potential for profitability? This is where projected financials come in handy.
Understanding Projected Financials
Projected financials are exactly what they sound like: a prediction of what the financial statements could look like over the next year to a few years. Derived from multiple sources, projected financials are not a guarantee of what the financials will look like. In fact, actual results will almost certainly be different. Historical financials, industry growth, and performance of similar companies can all be utilized to develop projected financials, but these assumptions are primarily based on past data and knowledge
Short term projected financials typically only go one year into the future, while long term projected financials may stretch from 2-5 years. These projections can lend insight to where the company is looking to grow, and what they believe can be reasonably accomplished in the near future. Projections beyond 5 years in the future are generally considered too far out to be accurate, and therefore should not be considered.
Examining industry growth and looking at competitors’ performance are also tools to see how the company might perform in the near term. Seeing how major players in the industry performed can lend insight to how this company may perform when they enter this segment based on their competitive advantage. While projected financials are never a guaranteed indicator of future performance, when evaluated with actual historical performance, they may provide a clearer look into the potential future performance.
Putting It All Together
When looking to invest in a startup with limited years of operations, and therefore limited years of financial statements, projected financials can be a valuable resource to evaluate potential performance. However, it is important to recall that actual performance can vastly differ from projected performance, and therefore should be taken with a grain of salt. But while not exact nor guaranteed, properly evaluated projected financials can provide a valuable glimpse of the potential trajectory of the business.
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.