How to Write a Business Plan for Raising Equity Capital – Explain Your Financials – Part 6

This is Video 6 of the “MasterClass
for Corporate Advisers and Entrepreneurs” on “Persuasive and Effective Business
Plans” in which I’m going to discuss raising equity capital – with a particular
emphasis on the section in your business plan which explains your financials. The
financial section of your business plan should condense the narrative of the
previous sections into numbers. It’s worth remembering that your profit and
loss account … balance sheet … and cash flow statement … are interlinked … and the
changes in one will therefore affect the other two … as they each measure a
different facet of your company’s current and forecast financial condition.
Prospective cash flow is the most important forecast … which should be
estimated for each month for at least two years into the future … using current
results as a starting point. A company’s profit and loss account … or income
statement … is traditionally compared to a video of a horse race … which is a
metaphor for a company’s trading activities in any one particular year …
whereas its balance sheet is comparable to a single photograph … of the result of
the race … at the finishing line: the ‘photo finish’ … effectively the year end
date. To stretch the metaphor a bit … before the race begins … a cash flow
forecast will enable an investor to assess the stamina of the horse (on which
they intend to place a bet) to clear the jumps as they occur … and to continue
competing until the end of the race. The cash flow forecast will therefore
identify whether or not your company has sufficient cash to meet its financial
obligations … as they fall due for payment. In spreadsheet form … it will schedule the
timing of all the cash receipts … that are anticipated to flow into the business
from sales … equity investment … bank borrowings etc … and the timing of all the
cash payments (without exception) which are expected to flow out of the business.
The positive or negative balance at the end of each month (the bottom cell in
each monthly column of the spreadsheet) … is carried forward as the opening
balance of the following month (the top cell in the next column) to show
the actual and respective cumulative total … of positive and negative cash
balances in the business …. as the year progresses … month by month. The highest
negative number in the totals of the monthly cash flow forecasts (at the
bottom in each column) … will indicate the additional equity or loan capital that
your company will require … to deliver the strategy described in your business plan.
The totals at the end on each row … will indicate the annual budget for that
particular item. To show that your company is robustly managed … there should
be two columns at the end of each row. The first entitled ‘most likely outcome’ …
and the second ‘the target’. When discussing your company later, therefore …
you can explain that the ‘most likely outcome’ contains the forecast figures
that you’ll be very surprised if you don’t hit … but the ‘target’ column contains
the figures you’re striving to achieve … and that your company operates on the
basis that ‘its reach should be always further than its grip’. It can’t be
emphasised too often … that profit is not cash. You can’t buy chocolates with
profits. Only with cash. Cash is fact. Every other line of a set of accounts is
a matter of opinion. To show that you fully appreciate this … you should
reconcile your profits to cash … to show how much of your reported profits
actually turn into cash. Potential investors will do this … so you might as
well do it for them. Profit is a number conjured up in accordance with legal rules
and accounting principles … which can be very flexibly … and often very
misleadingly applied. Cash is money … usually in a bank account. For example, the
net proceeds from rapidly growing sales … may be included in a company’s
accounts … as profits. But it’s unlikely that such profits … on their own … will
generate sufficient cash to finance a growing business … simply because
suppliers and employees usually require payment for their supplies and their work …
before customers pay the cash they owe … for the purchase of the company’s goods
or services. The resulting cash shortfall will impact each monthly total of the
cash flow forecast … which will show through as a negative number …
unless covered either by the equity subscribed by shareholders … or debt in
the form of a fixed term loan or an overdraft facility provided by a bank … or a
combination of the two. An apparently very successful company can therefore
suddenly collapse into liquidation … if it’s unable to pay its bills … as they
fall due … despite a very full order-book … and a long list of satisfied customers … who
have yet to pay for the goods or services the company has sold to them.
Consequently, potential investors and bankers need detailed assurance … that
your company will avoid such corporate death … by generating a sufficient cash
flow (not profits) … to keep the wheels of the business turning … or the horse
running. They’ll seek this assurance by analysing your cash flow forecast in
considerable detail . You should therefore be ready to answer very detailed
questions on your cash flow forecast … the makeup of which you should thoroughly
understand … so that you can explain, for example, where you’ve included a safety
margin for timing errors … and for unexpected contingencies. It’s also
useful to include in your business plan … an explanation of your policy on ‘income
recognition’: that’s to say, for example, do you consider an activity to have made a
profit when you receive a firm order … or when you start work on that order … or
when you finish the job … and have received cleared funds in your bank
account? Or do you book proportions of the expected final payment as ‘profit’ … at
specific stages of the job … as ‘work-in-progress’ … although you haven’t
received any cash payment at all for the job? An investor will usually accept any
reasonable policy on income recognition … provided it’s … consistent … and transparent.
So your business plan should describe your policy clearly. I should therefore
re-emphasise that it’s essential that you should thoroughly understand your
own numbers. It’s not sufficient to say that your cash flow forecast was drawn
up by your accountant … in whom you have complete confidence. Your accountant
doesn’t manage your company. Frequently, a management team will come unstuck … at
meetings with potential investors … because the spreadsheets of the business plan have been prepared by their professional advisers … and have been
insufficiently explained. Anything other than a very precise understanding of the
cash flow forecast … and its implications … will have an extremely negative effect
on potential investors or lenders. You should therefore undertake a ‘sensitivity
analysis’ (a what-if testing) of your spreadsheet numbers … so that you can
discuss, for example, a break-even analysis … under a number of probable and
possible circumstances … with suitable explanations of how such events will be
financed … should they occur. It’s not a good idea however to provide a choice of
optimistic … realistic … and pessimistic forecasts. This will merely encourage
potential investors to ignore the optimistic … and discount the
realistic … in favour of your pessimistic estimates. Instead, your figures should
portray a realistically optimistic view of the future … which you’re confident you
can defend when potential investors challenge the figures. When analysing
your company’s past performance forecasts … potential investors will also
be looking for the following information … which you should have readily
available explanations for: the total sum invested to date … the exact use proposed
for the funds to be raised … details of any significant dependence upon a major
customer or group of customers … any danger of over reliance upon sourcing
from a single supplier … a breakdown of fixed and variable costs … details of
bank loans and overdraft facilities … and other financing facilities …
such as factoring … leasing … and hire purchase … and the likelihood of
additional requests for funding … as the business expands. One of the only certain
forecasts that an investor can make … is that your company will need more cash … at
some time in the future. It’ll either need more cash to finance its growth … as
it does well … or more cash to finance its survival … if it does badly. Things very rarely stand still. Potential investors will therefore want to
forecast whether your company is likely to produce this extra cash … from its own
operations … or require further equity investment … or have a strong enough
balance sheet to support a larger loan from the bank. If it looks like your
company will require further equity capital … investors will decide whether
they’ll be prepared to produce this ‘second round financing’ … or whether they’re
happy to have their percentage shareholding diluted (that is: reduced by
the company’s issue of new shares to new shareholders to finance an increased
cash requirement). An appendix to the business plan should include a summary
of the most recent audited profit and loss account and balance sheet … together with
any draft or pro forma accounts … and the most recent monthly management accounts …
with brief explanatory notes … highlighting any special accounting
policies or deviations from best practice. Appendices can also include
details of customers … suppliers … and facilities … property and asset valuations…
banking and leasing … insurance and litigation. An appendix could
also usefully explain the company’s tax position … bearing in mind the potential
buyers of your company will be primarily interested in property taxes … and whether
interest or losses are tax deductible. That was Video 6 on raising equity
capital … with particular emphasis on explaining your financials. Video 7
will go one step further and adapt your business plan we’ve put together so far …
into an Information Memorandum for potential buyers of your company.

Author: Kevin Mason

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