Can Financial Due Diligence Predict Start-up Success?

As an angel investor, I’ve heard pitches from hundreds of start-ups. My investing track record is mixed. What angel investor’s track record isn’t?

As a person at Burkland responsible for talking with start-up prospects interested in Burkland strategic finance consulting services, I’ve talked with an even greater number of founders and CEOs. And as the CFO Practice Team Lead for Burkland, I’ve had the opportunity to ‘look back’ at those companies who have been successful, and those who haven’t, to reflect on what differentiates one group from another.

Is there a way to predict the success of a start-up? Can a due diligence process figure that out ahead of time and guarantee investing advice? The honest answer to the 2nd question is “No”. A follow-up response is “With good due diligence, the odds of investing success can be increased.”

With Burkland’s focus on Series Seed to C finance consulting we are uniquely positioned to evaluate the finance side of a start-up for predictors of success.

An excellent starting point to evaluate a company’s wherewithal for success is months of cash left determined by cash in the bank less forecast burn rate. Add in an estimate for collection on AR and subtract an amount for payment of AP. Less than 6 months is trouble as it can take that long, or longer, to raise funds. Plus the company raising funds loses negotiating leverage with each passing month. Twelve to eighteen months is a sweet spot whereby the company doesn’t need to be in fundraising mode (yet) and can focus on growing traction/the top line and thus, the value of the firm.

Once there is a preliminary look at months of cash left it’s time for a closer look at the balance sheet. First, look at the equity section. Is it negative or positive? No need to dive deep at this point though negative equity, while not unheard of for early-stage start-ups, can be cause for alarm.

Besides the cash balance and months of cash left, what does the AR Aging report look like? Days Sales Outstanding can help evaluate this. Less is better. What’s been the trend in the previous months? One should also make an assessment of collectibility based on the names on the report. If there is time and the company agrees, call a few aged AR customers and understand why they have not paid.

If there is IP on the balance sheet as an asset is it fairly valued? Is it being written down? Similarly, are fixed assets on the balance sheet being depreciated over a reasonable useful life?

Within 5-10 minutes of looking at the asset section of the balance sheet one can determine if the company a) has a basic understanding of accounting principles (we’ve seen a balance sheet that listed salaries as an asset) and b) is valuing their assets reasonably.

Looking at the liability section of the balance sheet may shine an even brighter light on the health of the business. An AP Aging will quickly tell you if the company is maintaining the cash balance that they have because they aren’t paying their bills. Are there payroll liabilities that need to be paid?

Are there loans or convertible notes on the balance sheet? Is their interest rate reasonable? Is the discount rate on the convertible note unusually high (>20% is a warning sign) or is the cap unusually low? High discounts and lows caps indicate the company was in a weak negotiating position. When do they mature or have they already matured? If the latter, why were they not paid back in the case of loans or converted in the case of notes?

Does the equity section of the balance sheet match the capitalization table? It should/must. If not, why not?

The P&L needs to be looked at to see if revenue exists and is being properly booked. Are the books cash or accrual? Revenue for customers with annual prepay contracts may only be recognized one month at a time through accrual accounting. If customer contracts have cancellation provisions is that being accounted for? Are sales commissions being properly computed? And paid?

High gross margins (>80%) can be a sign that COGS are not being recognized correctly. Low gross margins (<40%) can be a sign of bad unit economics, though may reflect the company does not have economies of scale yet. As important as the margins is their trend over time.

Quality of Earnings is an essential part of finance due diligence. For example is revenue being first recognized when a contract is signed, when a purchase order is received, or when terms required for the fulfillment of contract terms have been met? The latter is correct. The other two will cause revenue to be booked artificially early.

Depending on the industry of the business key metrics can provide quick insights. For example, what are the customer acquisition costs and payback period for a SaaS business? What are customer churn rates? If the company has had customers (and churn) for a long enough period of time what is the customer lifetime value? And for all metrics, what is the trend? Improving or...

Have tax returns been filed? On-time? In the needed jurisdictions? Is sales tax being reported and collected where the company has nexus?

In addition to the financials themselves take a look at the company finance processes and controls. Are bank statements and credit cards being reconciled monthly? Not doing this is a bright red flag as it almost certainly means the financial statements are not accurate. Speaking of bank statements, a scan of a few months of statements can speak volumes. Are there large irregular transactions? Are there lots of transactions with Founders or employees? Activity that doesn’t show up in the financials? All of these suggest potentially inappropriate activity.

Finally, what is the approval process? The founder/CEO should not be approving their own expenses. Expenses above a certain amount should have a 2nd approver. Burkland’s Controls Matrix is a useful guide here.

The above scratches the surface of financial due diligence. And doesn’t look at other important factors that contribute to success such as team, target markets, product, customers, or sales pipeline.

Sloppy finances or a ‘kick the can’ mentality about finance is often correlated with other poor business practices. The team of Burkland finance professionals - CFOs, controllers, accountants, and tax preparers - are ready to quickly assess the financial health of a company. Doing so can give an investor more peace of mind in the financial health of a potential investment and increases the odds of a successful return.

Learn more about Burkland's Financial Due Diligence Service.