The ultimate goal investors aim to achieve while helping out small businesses is significant profits. Therefore, for business owners, it's essential to provide investors with a clear understanding of how exactly their company will make such profits and do proper financial management and analysis.
Growth rate: how fast your company grows?
The first parameter usually assessed by potential investors in terms of corporate finance is the Growth Rate. This is often much more important than the revenues you currently have. Think about it from the investor's perspective: their return depends not on your size as a company at the moment but on how fast you grow.
The growth rate will vary for different metrics, and your business model defines which particular metric is the most important. Some common examples include MRR (monthly recurring revenue), ARPU (average revenue per user), number of users, user retention, etc. The common denominator for all such metrics is that their growth should result in your revenue and valuation.
Dividends and capital gains — what is the difference?
The next important criterion of financial ratio analysis is how the investors get a return on their investment. The two most common options are dividends and capital appreciation. Some businesses focus on supplying a steady low-risk flow of dividends. Alternatively, in a venture model, all earnings are reinvested in growing the business with the goal of increasing the price of shares as much as possible. There is also a hybrid model, implying that the business has an asset that generates income (say, land or real estate). This asset grows in value itself and generates revenue that can be distributed as dividends to investors. Different investors prefer different income models, which you should be aware of when approaching them.
Popular multiplicators: P/E (Price to Earning) and P/S (Price to Sales)
Investors pay attention to the ratio of your company's valuation or market capitalization to other financial metrics, such as revenue or income. This helps to understand whether the first metric is justified and whether they are not overpaying for the share they get. If investors pay even 30% more than the company is really worth, not only do they get a 30% lower return but potentially even lose money if the business's true worth does not increase.
The most common multiplicators are P/E (Price to Earnings) and P/S (Price to Sales) — the ratio of the share price to how much income or revenue respectively the company earns per share. Depending on a business model and how exactly the investors receive returns, other multiplicators might be more relevant. For instance, if investors primarily benefit from dividends or revenue distributions but not from asset growth, the most pertinent metric is Price to Free Cash Flow (P/FCF). If the company is more focused on increasing the value of assets, then the Price to Book (P/B) value reflects investment characteristics more precisely.
When it comes to what multiplicators are justified, there is no correct answer. Each company is different in its structure and communication with its clients. Therefore, the most leveraging multiplicator is determined individually for each business. There are at least three factors that define what multiplicators the market will accept.
The principal factor is the aforementioned growth rate. The company may be overpriced, but if it grows fast enough, investors will be happy to fund it because the returns are still going to be great. The competition among investors for good opportunities only makes this factor stronger. Hot, fast-growing startups can easily have a P/E ratio of 10, 30, or even 100. More traditional businesses that grow by 5-10% per year may have P/E ratios between 1.5 and 2.
The second factor is liquidity, which means the ease of selling securities. Publicly listed companies at large exchanges possess multiples between 20 and 50, even if they don't grow as fast as hot startups. Meanwhile, selling stock in private companies is quite challenging, so multiples are correspondingly lower.
Conditions you offer to investors also influence the multiple. How much power the investors will have over your company and how many guarantees you give them is a third significant factor. For example, if business consents to provide a high liquidation preference — a guarantee that they will receive at least 2x or 3x return on investment in your company — they can agree to a higher valuation because now, the risk of not getting returns caused by high valuation is reduced.
What is the velocity of money and unit economy?
Unit economics is an indicator of whether one client is profitable for your business. To understand unit economics, you first have to calculate all the revenue you receive from one client: the so-called lifetime value (LTV). After that, subtract from LTV the сustomer acquisition сost and the price of the goods/services this client buys.
For example, the client comes from advertising that costs you $5 per client; they spend $50 on products, which cost $20 to manufacture. In this case, your unit economy is that you make $25 per client.
To increase the accuracy of the analysis, you should calculate the unit economy for each segment of the customers separately. There are quite many nuances in product management for getting the unit economics right, so it ought to hire professional consultants or do significant research when doing such calculations.
The reason why investors care about the unit economy is that it defines the product's scalability. This metric is incredibly relevant for startups that raise money for rapid growth and scaling. The system is scalable only if the unit economy is positive, i.e. each new client actually brings money to the company instead of burning it.
A parameter that matters in the context of the unit economy is the velocity of money, that is, how quickly you can reinvest profits to fuel your growth. For instance, imagine there are two companies with good unit economics. Each spends $1 per client and earns $1.5 as an LTV, and each has raised a million-dollar investment. In this case, each can spend this million and make a million and a half.
Now let's say one company can reinvest in growth in 2 months, and the other can do it in 6 months. In such a scenario, the second company has earned 1.5 million dollars in 6 months, while the first company has an astounding 7.125 million dollars.
This example shows that unit economy is just as crucial as the velocity of money, i.e. how fast UE is recycled. This is especially true for companies whose main channel of attracting customers is sales or performance marketing, where the relations between the invested money and customers is very clear.
Discounted cash flow measures of return and the IRR method of DCF
The capital you have today and the exact same sum of capital in a year are two very dissimilar figures. The reason for it is that it's possible to invest the money you have right now in order to get additional returns. This phenomenon is called "the time value of money." Accordingly, a company that starts generating income and paying dividends faster is a better investment.
Discounted Cash Flow valuation is a method of traditional finance that takes this factor into account. In the DCF methodology, the value of a company is the sum of all the income it will ever generate, and the later the income, the more it is discounted to take into account the time value of money.
The discount rate itself is usually chosen based on the investment risk. It reflects the income that investors could have received by putting money into an alternative company with similar profitability, which is proportional to the risk. Therefore, the discount rate is a kind of reduction of the company's valuation to compensate for the investment risk: the higher the discount rate, the more future cash flow is discounted and the more the company's valuation falls, respectively, making this investment more profitable for investors.
The measure of profitability under the DCF model is called the Internal Rate of Return (IRR). As with the ratio, there is no such thing as good or bad IRR by itself. What matters is IRR compared to the discount rate. If it is significantly higher, the investment is solid.
Risk-return ratios that help investors assess existing or potential investments
The general rule of investing is that high-yield investments are always riskier. As a CEO, you need to be aware of the risk-return ratio your business possesses and position yourself appropriately while reaching out to relevant investors.
Some companies can deliver better returns with a similar level of risk. This is often true for small and medium enterprises that are riskier than corporate equity but not as risky as tech startups. The problem with such companies is that they are mostly private. Opportunities to invest in them are minimal, which makes them trapped in getting funding on bad terms for institutional investors and banks.
Define the profile of investors who would be interested in your offering
Based on the financial metrics, you should define the profile of investors who would be the most interested in your offering. Investors have different risk appetites, planning horizons, preferences regarding the return model, etc. You can find a fitting investor profile for almost any business economics. There are risk-hungry VCs looking for a fast-growing startup, millennials preferring businesses with stable and long-term cash flows to save some retirement money, and many other investor profiles. Your financial model should be an essential input in building a marketing campaign and investor targeting.
Why brand matters to investors, and how to make it work for you?
Facts tell — stories sell. The story of your brand matters as much as your financial performance.
People make decisions based on emotions and stories. This is your story that is a secret ingredient that distinguishes successful and failed campaigns. Neurological research demonstrates that the emotional part of the brain is responsible for decision-making. Individuals who have suffered brain damage on their limbic cortex (responsible for mood and motivation) can perfectly rationalize and deconstruct any possible outcome, pointing out its pros and cons, but can't actually make a decision.
In this case, your finances are the plot of the story. What kind of story is it? Is it about the low risk, good assets, general financial attractiveness, and consistently growing cash flow and dividend payments? Or is it about your fast growth after finding a product-market fit two months ago? One way or another, the secret to persuasion is inner consistency. For the story to be so, its beats should be clearly reflected in the numbers and the financial model.
Changing the terms of the investment if metrics are not good enough or too good
If your metrics fall outside the conventional ranges, you may consider changing the terms of the investment.
Suppose your performance is objectively not that good, which is completely normal. In that case, you should make the contract more favorable for the investor by providing more guarantees or reducing the valuation so that the offer looks safer from an investor's perspective. On the contrary, if your metrics are outstanding and you are already oversubscribed, feel free to twist an offering in your favor.
Long story short, you have to look at all the factors and financial business analysis holistically. It's also worth paying attention to the feedback from investors since the brand's story and offer are not written in stone and can be changed when you feel there's a need for it.