How to Read a Startup’s Financial Statements

This article was originally written by our KorePartners at StartEngine. View the original post here.

 

When considering which startups to invest in, there is some key information prospective investors would want to review and understand before making any investment decision. A lot of the information is presented to you on campaign pages, but if you want to review more detailed information about a company, you need to look at their:

  • Form C and “offering details” (for Regulation Crowdfunding offerings) or
  • Offering circular (for Regulation A+ offerings)

There are links to these documents on all of the campaign pages on StartEngine, so that you can review them, but they can contain a good deal of complex terminology that can be hard to understand.

One area that can be complicated to grasp is the company’s financial statement and the related analysis. It is one of the primary types of information prospective investors review to gain a glimpse into a company’s overall financial health.

Financial information can also help you identify trends of the business over time, so you get a better idea of the company’s potential future performance based on historical results. It can also provide you with a means of comparing a company’s performance to other companies in the same industry and stage of growth.

To make it easier for you to accomplish this, we have outlined some key terms and financial concepts to make it easier for you to review and understand a startup’s financial statements.

Note: a typical set of financial statements will include a balance sheet, income statement, statement of cash flow, statement of shareholder equity, and supplement notes. 

Income and Expenses

At some point in its lifecycle, a company must generate a sufficient amount of income to survive and grow (otherwise, it will continue to need outside sources of funding). So, how can you tell how much money a company is making, and how much it is spending? To determine this, you’ll need to take a look at the company’s Income Statement (for Regulation Crowdfunding’s offering details) or their “Statement of Operations” (for Regulation A+’s offering circular).

Gross Revenue

The first item presented on a company’s income statement is Gross Revenue. This is the amount of money the company has received by selling its goods and/or services. It is reported on the first line of the income statement, which is why you may come across people refer to gross revenue as “top line revenue” or simply “revenue.”

Cost of Goods Sold

After revenue, a company will deduct Cost of Goods Sold. This can also be called “Cost of Revenue” or “Cost of Services” and refers to all expenses that are directly related to the production of whatever products a company is selling or services it is performing. Sometimes a company may not have these costs on its income statement if it is an early stage pre-revenue startup that has not introduced its product/services to the market. These are also referred to as “variable costs” because they typically rise and fall in line with sales—simply put, producing more costs more.

Gross Profit

Once these costs are deducted, the resulting number is the company’s Gross Profit—the amount of money earned from the product or service sold. It is called a “Gross Loss,” if the sale of product or service loses money. In financial documents, losses are indicated by numbers in parenthesis, so for example ($200,000) would represent a loss of $200,000.

Operating Expenses

Operating Expenses, such as research and development expenses (money spent on innovation and technological advancement), “General and Administrative” expenses (day-to-day costs such as accounting, legal, utilities and rent) and many others are  deducted from gross profit or added to gross loss. These consist of all costs that are not directly attributable to the production of a product and/or service and are generally considered “fixed” costs because they do not rise or fall directly in line with sales.

Operating Profit/Loss

After considering these expenses, the resulting figure (gross profit minus operating expenses) is known as Operating Profit, or Earnings Before Interest and Taxes (EBIT). It is considered an “Operating Loss” or “Loss from Operations” when gross profit minus operating expenses results in a negative value.

Net Income

Once interest expense on outstanding debt and income taxes are deducted from Operating Profit/Loss, you arrive at Net Income. Conversely, if after deducting taxes and interest paid on the company’s debt results in a negative amount, it’s called a “Net Loss.”

This figure is referred to as a company’s “bottom line” due to the fact that it is typically the last item presented on the company’s income statement—much in the same way gross revenue is referred to as a company’s top line. Also, people will many times address a company’s net income or net loss as a percent of revenue, known as its “net profit margin,” which is used to measure a company’s overall profitability.

In the context of investing in startups, it’s worth noting that most companies will record gross losses, operating losses and net losses. Nearly all early-stage businesses are not profitable as funds are reinvested into growth and R&D. It’s why startups raise funding: to build the product that they can sell, to scale their operations to reach an economy of scale, to hire new employees, and a host of other reasons that help them grow towards that point of generating profit.

Net Worth: Understanding Balance Sheets

A company’s Balance Sheet presents their assets (anything the company owns that has value such as cash, inventory, accounts receivable, and real estate) and liabilities (what the company owes, such as unpaid invoices, taxes and debt). When you subtract all of the funds owed by the company from all of the assets it owns, you get the overall net worth (the book value of total assets minus total liabilities) of the company. Let’s start by looking at the asset side of the balance sheet.

Current Assets

The first category you will see is called, “Current Assets.” These are all assets that are considered cash or assets that the company expects will be converted into cash within a year. This includes cash and cash equivalents (any asset that can be immediately turned into cash, such as foreign currencies, short term government debt securities called Treasury Bills, and certificates of deposit), accounts receivable (the amount of money you are owed for products and services delivered that have not been paid for), inventory, prepaid expenses and other items.

Current assets are a major element of a company’s working capital (current assets minus current liabilities) that presents the amount of funds available to pay off short-term or current liabilities, which we will define later. The more working capital a company has, the greater its liquidity, which implies a more healthy financial position.

Long Term Assets

Next up on the balance sheet are Long Term Assets that consist of non-current assets that have a useful life of longer than 1 year. They include: property and equipment; long term investments; intangible assets such as patents, copyrights, trade names and goodwill; and software.

Long term assets are typically presented on the balance sheet at their cost value minus accumulated depreciation, which equals their net book value. Significant growth in this category can indicate that a company is focusing on or moving into or expanding lines of business that require a greater investment in fixed assets.

Current Liabilities

Current Liabilities consist of all expenses that are payable within 1 year, or sometimes within one operating cycle (the time period required to receive inventory, sell it and collect cash from the sale).

These short term liabilities include accounts payable (for example, unpaid invoices to suppliers), lines of credit, short term loans, accrued expenses (owed money for which no invoice has been submitted), taxes payable and payroll liabilities.

Current liabilities are also used in the calculation of working capital in order to ascertain a company’s level of liquidity as described above. This can provide important insight into the company and give you a sense of whether the company is generating enough revenue and cash in the short term to cover its bills.

Long Term Liabilities

Long Term Liabilities are made up of all obligations that are not due within 1 year of the date the balance sheet was prepared or during the company’s operating cycle. Examples of these liabilities are bonds payable, long term debt, deferred taxes, mortgage payable and capital leases.

A company is over burdened by excessive long term liabilities can equate to high monthly payments and lower cash flow, but some amount of long term obligations can be positive. This is due to the advantages that a company can gain through access to long term financing at low interest rates that can help it expand over a longer time period.

Net Worth

Finally, we come to Net Worth, which is most often referred to as “shareholders equity.” It is calculated by subtracting total liabilities from total assets and represents the amount of money a company would have if it ceased operations and paid off all of its debt. It is calculated the same way you would calculate your personal net worth—you would add the total value of everything you own then subtract all the money you owe.

Banks use this number as a metric for lending decisions because if a company’s assets far exceed its liabilities, it indicates a healthy financial position. On the flip side of the coin, if a company’s net worth is negative, it just means that the amount of money it owes exceeds the value of its assets. It should be noted that this is a common financial situation for an early stage startup that is trying to establish a foothold in its target market and continue to grow until its net worth is positive.

Cash Flow

The Statement of Cash Flows presents the net cash flow for a company over a given time period. It shows how cash enters and leaves a company from three main activities:

  • Operations (sales, inventory, accounts receivable, accounts payable)
  • Investing (buying and selling of assets and equipment)
  • Financing (selling of bonds, stock and paying off debt)

If an activity results in cash flowing into the company, it is shown as a positive number. If an activity causes cash to flow out of the company, it is shown as a negative number and placed in parentheses. E.g. $100,000 indicates a positive value, and ($100,000) indicates a negative value.

Cash Flows From Operating Activities

Cash flows from operating activities equates to how much cash has been spent or received from the company’s operations. One item is net income, which supplies cash to a company, or net loss, which indicates a flow of cash out of the company.

Depreciation expense (a yearly decrease in the value of a fixed asset over time resulting from normal wear and tear) and amortization expense (the yearly write-off of the value of an intangible asset over its useful life—e.g., a patent that is granted for 20 years has a 20 year useful life) are non-cash expenses subtracted from gross profit on the income statement. As such, they are added back since they are tax deductable expenses that do not deplete cash on hand.

Changes in working capital (current assets minus current liabilities) are also considered on the statement of cash flows. For example, if the company collects more cash from its receivables, cash increases. If it pays down its accounts payable, then that would reduce the amount of cash the company has on hand.

Investing Activities

Cash used for investing activities include cash spent on long term assets such as real estate, equipment (also called “capital expenditures”), patents, stocks and bonds. Conversely, gains on the sale of long term assets are recorded as cash received by the company. For example, if a company sold a warehouse, that would indicate a positive cash flow, whereas the purchase of stock in another company would constitute a negative cash flow.

Financing Activities

Finally, if a company raises money from investors by issuing securities such as convertible notes or stock, this would result in a positive cash flow to the company. When the company makes payments on its debts or buys back shares, it results in a negative cash flow.

Conclusion

And when all cash inflows and outflows are considered, the resulting amount of cash left over is a company’s net cash position. If a company shows an overall negative cash flow over time, the rate at which it is spending its cash reserves is known as its burn rate. The burn rate is usually quoted in terms of cash spent per month. 82% of startups fail due to the lack of cash flow necessary to survive and grow.

Based on the burn rate, you can figure out the company’s runway, which tells you how long a startup can survive before it will need to earn positive cash flow or raise additional capital (if the company’s finances remain unchanged). A startup’s runway is equal to its total cash reserves divided by its burn rate.

Understanding a company’s financials can help you make a more educated and informed decision when choosing the right startup to invest in. Once you have a good idea of what all of the terms mean, financial information will become easier to understand and faster to review, and in turn, investing will become a more enjoyable experience.

Investing in Startups 101

This article was originally written by our KorePartners at StartEngine. You can view the post here

The high-speed world of startups, and the risks of investing in them, are well documented, but startup investing can be complicated and there is a lot of information you should know before making your first investment.

This article will try to answer the question “why should you invest in a startup?” by giving you information about the process and what to expect from investing in an early-stage business.

Why invest in startups?

Through equity crowdfunding, you can support and invest in startups that you are passionate about. This is different than helping a company raise capital via Kickstarter. You aren’t just buying their product or merch. You are buying a piece of that company. When you invest on StartEngine, you own part of that company, whether it’s one you are a loyal customer of, a local business you want to support, or an idea you believe in.

Investing in startups means that you get to support entrepreneurs and be a part of the entrepreneurial community, which can provide its own level of excitement. You also support the economy and job creation: in fact, startups and small businesses account for 64% of new job creation in the US.

In other words, you are funding the future. And by doing so, you may make money on your investment.

But here’s the bad news: 90% of startups fail. With those odds, you’re more than likely to lose the money you invest in a startup.

However, the 10% of startups that do succeed can provide an outsized return on the initial investment. In fact, when VCs invest, they are looking for only a few “home run” investments to make up for the losses that will compose the majority of their portfolio. Even the pros expect a low batting average when investing in startups.

This is why the concept of diversifying your portfolio is important in the context of startup investing. Statistically, the more startup investments you make, the more likely you are to see better returns through your portfolio. Data collected across 10,000 Angellist portfolios supports this idea. In other words, the old piece of advice “don’t put all your eggs in one basket” holds true when investing in startups.

Who can invest in startups?

Traditionally, startup investing was not available to the general public. Only accredited investors had access to startup investment opportunities. Accredited investors are those who:

  • Have made over $200,000 in annual salary for the past two years ($300,000 if combined with a spouse), or
  • Have over $1M in net worth, excluding their primary residence

That meant only an estimated 10% of US households had access to these opportunities. Equity crowdfunding changes all of that and levels the playing field. On platforms like StartEngine, anyone over the age of 18 can invest in early-stage companies.

What are you buying?

The Breakdown of Securities Offered via Reg CF as of December 31, 2020

When you invest in startups, you can invest through different types of securities. Those include:

  • Common stock, the simplest form of equity. Common stock, or shares, give you ownership in a company. The more you buy, the greater the percentage of the company you own. If the company grows in value, what you own is worth more, and if it shrinks, what you own is worth less.
  • Debt, essentially a loan. You, the investor, purchase promissory notes and become the lender. The company then has to pay back your loan within a predetermined time window with interest.
  • Convertible notes, debt that converts into equity. You buy debt from the company and earn interest on that debt until an established maturity date, at which point the debt either converts into equity or is paid back to you in cash.
  • SAFEs, a variation of convertible note. SAFEs offer less protection for investors (in fact, we don’t allow them on StartEngine) and include no provisions about cash payout, so you as an investor are dependent upon the SAFE converting into equity, which may or may not occur at some point in the future.

Most of the companies on StartEngine sell a form of equity, so the rest of this article will largely focus on equity investments.

How can a company become successful if they only raise $X?

Startup funding generally works in funding rounds, meaning that a company raises capital several times over the course of their life span. A company just starting out won’t raise $10M because there’s no indication that it would be a good investment. Why would someone invest $10M in something totally unproven?

Instead, that new company may raise a few hundred thousand dollars in order to develop proof-of-concept, make a few initial hires, acquire their first users, or reach any other significant business developments in order to “unlock” the next round of capital.

In essence, with each growth benchmark a company is able to clear, they are able to raise more money to sustain their growth trajectory. In general, each funding round is bigger than the previous round to meet those goals.

When do companies stop raising money? When their revenue reaches a point where the company becomes profitable enough that they no longer need to raise capital to grow at the speed they want to.

What happens to my equity investment if a company raises more money later?

If you invest in an early funding round of a startup and a year or two later that same company is raising more money, what happens to your investment? If things are going well, you will experience what is known as “dilution.” This is a normal process as long as the company is growing.

The shares you own are still yours, but new shares are issued to new buyers in the next funding round. This means that the number of shares you own is now a smaller percentage of the whole, and this is true for everyone who already holds shares, including the company’s founders.

However, this isn’t a problem in itself. If the company is doing well, in the next funding round, the company will have a higher valuation and possibly a different price per share. This means that while you now own a smaller slice of the total pie, the pie is bigger than what it was before, so your shares are worth more than they were previously too. Everybody wins.

If the company isn’t growing though, it leads to what is known as a down round. A down round is when a company raises more capital but at a lower valuation, which can increase the rate of dilution as well as reduce the value of investors’ holdings

How can I make money off a startup investment?

Traditionally, there are two ways investors can “exit” their investment. The first is through a merger/acquisition. If another company acquires the one you invested in, they will often offer a premium to buy your shares and so secure a controlling ownership percentage in the company. Sometimes your shares will be exchanged at dollar value for shares in the acquiring company.

The other traditional form of an exit is if a company does an initial public offering and becomes one of the ~4,000 publicly trading companies in the US. Then an investor can sell their shares on a national exchange.

Those events can take anywhere from 5-10 years to occur. This creates an important difference between startup investing and investing in companies on the public market: the time horizon is different.

When investing in a public company, you can choose to sell that investment at any time. However, startup investments are illiquid, and you may not be able to exit that investment for years.

However, equity crowdfunding can provide an alternative to both of these options: the shares sold through equity crowdfunding are tradable immediately (for Regulation A+) and after one year (for Regulation Crowdfunding) on alternative trading systems (ATS), if the company chooses to quote its shares on an ATS. This theoretically reduces the risk of that investment as well because the longer an investment is locked up, the greater the chance something unpredictable can happen.

Conclusion

Investing in startups is risky, but it is an exciting way to diversify your portfolio and join an entrepreneur’s journey.

Equity Crowdfunding Platforms (RegCF)

As of 02 JUNE 2020, there are 51 active RegCF Equity Crowdfunding Platforms helping companies raise up to $1.0M USD.

We are all anticipating that RegCF is going to be potentially increased to a $5 million funding cap.   The SEC has proposed this increase, along with some other changes, and many observers expect the Commission to move forward with a higher funding cap.    

We recently did a Q&A with  Wefunder on what RegCF companies require.

We have compiled the list of 51 Active Equity Crowdfunding Platforms along with the sectors they serve.

Company Name URL City State Sector
Bioverge Portal, LLC https://www.bioverge.com/ San Francisco CA Healthcare
Buy the Block https://buytheblock.com/ Denver CO Community
CollectiveSun, LLC http://collectivesun.market/ San Diego CA Social Ventures
Crowd Ignition https://crowdignition.com/ New York NY General
CrowdsourcedFunded https://crowdsourcefunded.com/ Chicago IL General
EnergyFunders Marketplace http://www.energyfunders.com/ Houston TX Energy
EnrichHER Funding, LLC https://ienrichher.com/ Atlanta GA Loans
Equifund Crowd Funding Portal Inc. www.equifundcfp.com Kanata ON General
EquityDoor, LLC https://equitydoor.com/ Austin TX Real Estate
Flair Portal ( Flair Exchange) https://www.flairexchange.com/ Vancouver BC Gaming
Flashfunders Funding Portal www.flashfunders.co Sherman Oaks CA General
Funders USA https://www.fundersusa.com/ Newport Beach CA Technology
Fundit http://fundit.com/ Fairfield NJ General
Fundme.com, Inc. www.fundme.com Murray UT Technology
Fundopolis Portal LLC https://www.fundopolis.com Boston MA General
GrowthFountain Capital www.growthfountain.com New York NY General
Honeycomb Portal www.honeycombcredit.com Pittsburgh PA General
Hycrowd https://www.hycrowd.com/ Jersey City NJ General
Indie Crowd Funder www.indiecrowdfunder.com Los Angeles CA Film
Infrashares Inc. https://infrashares.com San Francisco CA Infrastructure
IPO Wallet LLC https://ipowallet.com/ https://invest.ipowallet.com/ Sachese TX General
Jumpstart Micro www.jumpstartmicro.com Bedford MA General
Ksdaq https://www.mrcrowd.com Monterey Park CA General
MainVest, Inc. https://mainvest.com/ Newburyport MA General
Merging Traffic Portal llc www.mergingtrafficportal.com Orlando FL General
MinnowCFunding www.minnowcfunding.com Pasadena CA Real Estate
MiTec, PBC (Crowdfund Main Street) https://www.crowdfundmainstreet.com/ Fremont CA Impact
NetCapital Funding Portal www.netcapital.com Lewes DE General
NSSC Funding Portal (SmallChange) www.smallchange.com Pittsburgh PA Real Estate
OpenDeal (Republic) www.republic.co New York NY General
Pitch Venture Group LLC https://letslaunch.com/ Houston TX General
         
Raise Green, Inc. http://www.raisegreen.com Somerville MA Impact
Razitall www.razitall.com Basking Ridge NJ General
SeriesOne https://seriesone.com/ Miami FL General
SI Portal (SeedInvest) www.seedinvest.com New York NY General
Silicon Prairie Holdings, Inc. https://sppx.io/ St. Paul MN General
         
SMBX https://www.thesmbx.com/ San Francisco CA Bonds
Sprowtt Crowdfunding, Inc. https://www.sprowttcf.com/ Tampa FL General
         
StartEngine Capital www.startengine.com Los Angeles LA General
STL Critical Technologies JV I, LLC (nvested) www.nvstedwithus.com St. Louis MO General
         
Title3Funds www.title3funds.com Laguna Beach CA General
Trucrowd www.us.trucrowd.com https://fundanna.com
https://cryptolaunch.us
https://musicfy.us
Chicago IL General
VedasLabs Inc. https://vedaslabs.io/ New York City NY General
Vid Angel Studios (VAS Portal LLC) https://studios.vidangel.com/ Provo UT Film
Wefunder Portal https://www.wefunder.com San Francisco CA General
Wunderfund www.wunderfund.co Cincinnati OH General
WWF Funding Portal LLC https://www.waterworksfund.com/ Detroit MI Water

If you have any questions about how we can help you with your RegCF contact us

lily@koreconx.io