Investors analyze your financials to compare your historical performance with your projections, to find pitfalls or overlooked assumptions that could threaten the company’s viability and growth, and to find other risks to your business plan.
You can anticipate their concerns and questions by analyzing your own financials the way that they will. Perform this analysis yourself, or have an experienced financial analyst or entrepreneur give you a third-party, objective review.
When you find gaps, risks, or unknowns in your financial model, don’t hide them - write them down, think of how you will deal with them, and be honest about them. You will build trust and confidence with investors, your board, and your team.
The major components of financial due diligence
The financial due diligence process varies widely by investor, but it will contain some or all of the following criteria:
Revenue Analysis
Operations Expenses and Margins
Cash Position and Burn
Cap Table
Use of Funds
Implied Valuation and Deal Terms
Returns Analysis
Revenue Analysis
Investors want to understand how you generate revenue and how much risk there is in the revenue. Review your financial model, and ask these questions:
Is there demonstrated traction (revenues, users, clients, orders etc.)?
Are there diversified revenue streams, or is the revenue from only one source?
Does the company have a repeatable sales process?
Does the company have recurring revenues?
Is there a track record of strong year-over-year (YoY) or month-over-month (MoM) historical growth?
Are market estimates and share assumptions reasonable?
Operations Expenses and Margins
Investors want to understand your cost structure and how you plan to be profitable. Review your financial model, and ask these questions:
Are the historical gross margins high compared to industry averages?
Are the historical EBITDA margin high compared to industry averages?
Are the historical net profit margin high compared to industry averages (when applicable)?
Cash Position and Burn
Investors want to understand how much runway you have, and whether you have enough capital to reach the milestones you’ve planned. Review your financial model, and ask these questions:
Is there enough cash on hand is enough to cover operating expenses (losses) for a 12-month period?
Is the fundraising target is in line with potential monthly burn?
Is there a short cash conversion cycle?
Cap Table
Investors want to understand you can effectively incentivize current and future employees, executives, and investors. Review your financial model, and ask these questions:
Is my cap table ready to accept additional shareholders?
Who are the current investors in the company? What are the terms of their investment?
Are they value add investors?
Does the company have enough room in the cap table to take investment necessary to grow while still ensuring employees and executives are well compensated?
Use of Funds
Investors want to understand your cost structure and how you plan to be profitable. Review your financial model, and ask these questions:
Is the use of funds clearly allocated and logical to grow the company?
Will this investment drive enough value? How?
Implied Valuation and Deal Terms
Investors want to understand your cost structure and how you plan to be profitable. Review your financial model, and ask these questions:
What is the valuation of the current round and what are the investment terms?
Is the valuation is on par with market data, internal operational growth and/or cash distribution to shareholders?
Is fundraising target is in line with potential valuation (when applicable)?
Returns Analysis
Investors want to understand their returns timeline and potential amount. Review your financial model, and ask these questions:
What is the probability of an exit?
If the company is successful, is the exit scenario large enough to provide the types of returns our fund needs?
If there is no exit, how will investors make money?
If the company is successful, how much will I make in returns?
Creating a financial highlights brief
When you are done, we encourage you to prepare a financial one-pager that you can share with an investor to give them the takeaways and most important points from your analysis. You will save them time, and build valuable trust and confidence.