How to position your firm (financially) to attract third-party investment
If there’s one goal shared by all investors, it’s the obvious desire for a substantial return on any investment they make.
For entrepreneurs, investors are a lifeline of both funding and in some cases even insights and support (be it direct or indirect) in the drive to make their organizations a success. Many business owners look for an investor who will not only provide cash to finance the growth of a company, but who will also share their experience and expertise, in some cases even assuming an active role in the business as an advisor, c-suite executive or board member. Equity investors, who typically look for a long-term capital return—often with an ongoing dividend income stream—quite frequently fall into this category.
Other entrepreneurs might seek investors willing to inject cash, but who want only a tertiary role (if any) in running the business. That usually means they want a debt investor interested in an ongoing income and principal repayment, and little else.
A major question to consider: which of these types of investors better suit the operational needs and growth vision for your business? We’ll explore that issue in a later blog, but what’s important to note here is that organizations need to set a strategy and follow several key steps to position their firms financially to attract any kind of investment, be it of the debt or equity kind.
It starts by preparing a viable business plan, which must be specific, comprehensive and realistic—not necessarily long and complicated. Investors want to know your business objectives and growth plan, whether you’ve considered the full array of factors that might impact your success, and whether you’ve set realistic milestones to help guide your progress.
A business plan isn’t intended simply to sell a brilliant idea. The very best include a practical action plan to implement the idea and demonstrate your understanding of what it might take to get the business off the ground or take it to the next level. It also helps to demonstrate how you plan to spend investors’ funds—a key consideration for anyone being asked to invest in an organization, no matter how potentially successful.
Next, you’ll need to provide quality financial information to support the plan. That means including a statement of earnings to demonstrate profitability and whether the business will generate a return for its investors. The package must also include the company’s balance sheet—a snapshot of the company’s current financial health (assets compared to debts)—and a cash flow statement to demonstrate an ability to generate cash and to explain how it’s being used to fund ongoing operations.
There are several key financial indicators within those statements that investors will analyze closely:
EBITDA – Earnings before Interest, taxes, depreciation and amortization. This metric is especially important to debt investors because it’s often used in the calculation of debt service ratios. It measures the company’s ability to pay interest and principal.
Current ratio – This figure depicts current assets over current liabilities and measures short-term liquidity. Businesses should try to maintain a ratio of at least 1:1. A ratio less than one may indicate a financial problem because it means the business lacks the liquid assets to pay off its short-term debts as they become due. However, a ratio of greater than one can also be a red flag, especially for equity investors, because it’s often interpreted as an inefficient use of liquid assets. For example, that surplus could be used to expand operations, to invest for a greater return and to pay off debt to reduce interest payments in future, which would increase the accumulative earning/equity in the business.
Debt to equity ratio— This is a measure of total liability over net worth/equity that measures financial leverage. The higher the ratio, the higher the risk, which explains why neither debt nor equity investors like to see a high debt to equity ratio. Creditors regard a highly leveraged business as having limited ability to service additional debt. For equity investors, higher debts are a sign that they have a smaller piece of the pie—and that all liquid assets may be sucked up by creditors during difficult periods such as a recession.
Cash generated from a different source—The focus here is on the business’ ability to generate steady cash inflow from its daily operation when cash from investments or financing are not recurring.
For the preceding three items, the ideal ratio to attract investors will vary depending on your industry. It’s also important to note that investors may also look at more specific ratios like days sales outstanding and inventory turnover.
Days Sales Outstanding—This is the average of accounts receivable divided by sales multiplied by 365 days. This simply measures how well the business collects cash from its credit customers—the lower the number, the faster the collecting cycle, and the more liquid the business.
Inventory Turnover—This figure measures the cost of goods sold over average inventory and is an indicator of how efficiently the business manages its inventory. A higher number means the business is able to sell its inventory faster, turning its inventory into sales/cash. It also indicates better control of inventory to keep stocking costs lower.
Net worth—This is the company’s value. When book value is significantly lower than market value, the potential investor should be notified so he or she understands the true value of the business. Certain accounting standards better explain fair value on certain assets and provide investors with additional information.
Lastly, investors want to see a coherent exit strategy. They want to know how they can safely pull out their investments in a relatively easy manner if necessary—and if they know their investments are protected, they’re more likely to invest. An easy exit can be determined by:
- The availability of financing from different sources for commitments from exiting equity owners, or the ability to generate financing from other sources
- The liquidity of the asset and the ability to cash out investments
Your ability to attract third –party investment hinges on the readiness of these metrics and their relative health. It’s no surprise that strong performance often makes companies a magnet for investors. But if your financial metrics lag behind industry standards or those of direct competitors, it makes sense to bolster performance or to consider alternative forms of investment until they improve.
Cecily Huang, MMPA, CPA, CA, CPA (Illinois)