In my last column (BusinessWeek.com, 10/24/07), I described three common reasons financing deals fall through based on the 200-plus deals with which I've been involved. Now let's say you've aced—or at least passed—your financier's due diligence of your management team, technical capabilities, and sales and marketing strategy. The last hurdle between you and a term sheet is financial due diligence. In this column, I offer advice on preparing for and making it through the process.
There are three areas of financial due diligence. The first is an explanation of how you plan to use the funds. The second is an explanation of your business model/budgets. The third is a legal review. It's essential to be able to provide a realistic assessment of your business, clearly articulate the reason for the financing, and explain for what exactly the dollars will be used. Use of proceeds is where many deals fall apart. Here is a checklist I put together that will help you. Good luck.
1. Financing Needs and Proposed Terms
1.1 Objectives. Why do you need the financing? What are your goals?
1.2 Use of proceeds. Where will the capital be deployed, specifically? New hires: who? New products: what?
1.3 Proposed closing date. Make sure this is realistic. Agree on the date with your financiers.
1.4 Stock option plan. Is it adequate? How many shares are approved? Issued? What's the vesting schedule? Are any founders' shares expected to be vested on closing?
1.5 Board composition. Who is currently on the board? What are their key areas of contribution? I always caution against having a full board prior to an early financing—often board members need to be removed. How will this be handled? The chief executive officer must suggest how, finesse the current board members to set expectations, and with luck, get some members to offer to step down.
1.6 Vesting/compensation for founders and key employees. Don't expect to recoup accrued salary—that's called sweat equity. Do ask to be vested 25% if you've been working for free for at least six months.
1.7 Valuation and price per share. This is where the financier will look at your last financing round, whether it was internal or external, and gauge the valuation jump and determine if it wants to change its terms.
2. Business Model/Budgets
2.1 Cash on hand and monthly burn rate. You'll want to list today's cash position as well as post-funding. Are you living on air now—or roots and berries? Keep expecting to do so post-financing. Steak dinners will be served once massive traction has been achieved. Keep your operations lean in the meantime. Don't scare financiers away with a rapidly increasing burn rate.
2.2 Timetable for funding. What are the stages/deadlines to be achieved? Get agreement here on what, where, when, how the financing will get closed.
2.3 Short-term objectives. What you'll achieve before the financing comes in and in the first few months.
2.4 Funding options. Lease lines? Line of credit? Bridge loan to tide you over until the financing is closed? Get a bridge if you can—once the financier gives you some money, it's a lot easier to get more. They've already got skin in the game.
2.5 Strategic milestones. What will you achieve in the next year that will contribute to your company achieving momentum?
2.6 Revenue assumptions. List all major assumptions you are making in order to achieve your revenue goals. These will include marketing plans succeeding, partners delivering on commitments, expectations of sales cycle and customer acquisition, among other assumptions.
2.7 Gross profit margins vs. competitive norms. How profitable will your business be? When? Again, what expectations are you making in your profitability assumptions? Now pad your assumptions by nine months. Why? Because stuff happens. Better to be profitable early than embarrassingly late.
2.8 Revenue recognition. Explain how you are recognizing revenue. How soon can you bill for booked revenue? For example, over what period of time do you amortize a multiyear subscription paid up front but recognized monthly? Deal with all thorny revenue issues here.
2.9 Staffing plan. When are you hiring whom? What assumptions (such as sales) are you relying on to cost-justify your revenue ramp?
2.10 Monthly expense budgets. What are your monthly operational expenses? What are your baseline vs. variable expenses (such as exceptional product launches and temporary needs for contractors)?
2.11 Equipment budget. What are your capital expenditures and how will you address them? Will you spend financing proceeds or get an equipment lease line? Can you use expensive manufacturing facilities or equipment after hours by leasing it as needed from a larger company?
2.12 Financial statement projections. Prepare the following:
A. Best case.
B. Worst case.
C. Likely case.
D. Date range for breaking even.
2.13 Balance sheet and cash-flow forecast.
2.14 Detail of current liabilities. Don't be shy here—lay it all out for the financier to see.
2.15 Future funding needs.
A. Project "cash out" date. When do you expect to run out of cash? Better start raising your next financing six months beforehand. Will your financiers plan on bridging you if need be?
B. Critical milestones. What key milestones must you achieve to be worthy of a significant increase in valuation for your next financing round?
C. What are your likely sources/interested parties and timing for next funding?
3. Legal Review
3.1 Legal entity and capital structure. What is your corporate structure? What does your capitalization table look like (who owns what percentage of your company)?
3.2 Unusual or significant unrecorded liabilities. Be straight here—list everything.
3.3 Stock option plan. Have your attorney review it.
3.4 Contracts with advisers. Duration? How vested are they? What value are they adding?
3.5 Intellectual property. Are you pursuing IP protection? What, specifically? How far into the process are you?
3.6 Employment agreements, if any.
3.7 Tax matters. Have your accountant render an opinion—this will be minor if you're a startup.
3.8 Potential litigation. Any possibilities? Even if it's fraudulent, if someone has accused your company of patent infringement or anything else, you must disclose this.
Phew. I'm bleary-eyed—how about you? By using the above checklist to prepare, I hope you'll sail through the most tedious aspect of a financing, and get the green you're dreaming of.