Sanity Tests

Building models for really young companies is distinctly different from what you may be doing in investment banking or similar financial jobs — especially if the company is pre-revenue and has no historical financial data. The purpose of building models at this stage is to run a simple sanity check.

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You really just want to see if what the entrepreneur is proposing makes financial sense. Here are a few examples of what might be considered insane:

  1. Projecting sales volumes that exceed total market size (even, say, 10% market penetration is often a bit too hopeful)
  2. Assuming incredibly low churn/ incredibly high conversion
  3. Not including R&D expenses
  4. Growing revenues rapidly without hiring a proportionate amount of talent

Most startups are burning cash at the beginning. The sales volumes aren’t supporting the expenses, and sometimes they haven’t been able to get their variable costs low enough to even make money at the unit level. This is normal. In fact, many VCs use a popular

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metaphor to explain the financial life cycle of successful startups: the hockey stick. When you get into venture, this J-curve will become all too familiar. Every entrepreneur wants to say, “well we’re burning cash now, but eventually we’re going to take off like a rocket ship.” That’s a nice story, however often it’s not much more than just that.

 

So, when you’re constructing a model, you’re really trying to just tell a story, and ask a few critical questions. What does the company need to do to become cashflow positive? What expenses are associated with meeting those objectives? Are these assumptions reasonable? What should their financing strategy be? What’s a reasonable return multiple I can expect from my investment in 5-7 years? What’s the IRR for that? How much will my equity be diluted down the line if I don’t do my pro-rata?

Once you’ve passed this sanity check, you’ll need to evaluate some of their metrics from what you’ve built.

Maximum Negative Cumulative EBITDA

Calculating how much negative cash flow a startup accumulates from their projections can help you create a financing strategy. The timing of this is also critical. It is actually quite normal for this number to get quite high for early companies. They should expect multiple rounds of financing. However, it’s important to make sure they have an appropriate amount of runway to grow their revenues, say 18-24 months. Failure to meet milestones and grow revenues when raising a premature round could lead to excessive dilution, which isn’t good for the entrepreneur or the investor. You need to be able to anticipate this so that the entrepreneur raises the appropriate amount of capital, not too much or too little.

However, this metric can also be a bit excessive. If the projections here amass to a huge number that isn’t typical of the industry the startup is in, their raise for a bridge to A round could look a little more like a pier.

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Gross Profit Margin

Many tech companies are often losing money quarter over quarter, but you want to make sure that there are significant cash flows. The free cash flow a startup create gives the company independence from outside financing. Significant expenses in R&D or marketing can be supported by their own sales volume, rather than raising large rounds over and over. Considerable margins may also give a startup the ability to quickly generate cash, or even rebound from non-dilutive debt.

Seasonality

Is there any degree of seasonality to sales? For example, we all know that pumpkin spice latte’s sell more in the fall/winter. If there is a serious amount of seasonality to your sales, how are you accommodating that? Do you use short-term contracts for some of your employees? Are you oversubscribed on fixed costs that could cause a serious issue when sales fall?

Capital Efficiency 

How much revenue is generated from capital spent? In other words, if I put in $3M into a deal, how much revenue will the entrepreneur be able to generate with that? Low capital efficiency could also cause an unnecessary amount of financing rounds, which will dilute your equity share.

 

These are all boxes that need to be checked. Often, first-time entrepreneurs don’t look too far into the future and can be a bit heads-down focused on product. It’s your duty as a potential investor and equity partner to not necessarily dock an entrepreneur for not thinking of some of these things, but to advise and create a strategy that passes the sanity test.

Often, entrepreneurs have a great team and product, but not the best strategy — and that’s ok! A plan can be changed, but a team cannot.

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TheBoisfonBlog

I'm an aspiring startup guru. I'm looking to learn anything and everything about startups and venture capital — and share my findings along the way. This blog is in part simply a way to formulate and collect my thoughts. If this becomes something popular where people are giving feedback, communicating, and learning, great! If not, no harm no foul — I'm just here to share.

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