Art of Accounting: What potential investors must have

A friend’s son asked if he could meet with me, and I was glad to meet. He is a college business student, and I thought he wanted some career advice. Instead, he told me he was representing a business startup and asked if I would like to invest in it and be able to double my money within two years.

My immediate response is that I am in a situation where I no longer want to do anything to make money other than with the conservative portfolio I already have; I am concerned about not losing any of what I have and not reducing my cash flow, so I will have to pass on this “opportunity.”

Since I like helping young people get started in business, I asked about the business and requested to see the investor package, suggesting I might be able to offer some tips on raising the needed funding. He handed me a single sheet of paper acknowledging receipt of the investment amount, saying I would receive 1% of the ownership for every $10,000 invested with a maximum permitted investment per investor of $100,000. They were raising a total of $300,000. It also said that the plans were to have an IPO within two years. There were spaces to fill in the amount invested and for my signature. Nothing about the type of business, who the managers were, or any business plan or financial projections.

It turns out he was “hired” as a salesman to approach his parent’s friends for this “ground floor” opportunity. I asked him how much he was being paid, and he said he was told he would be taken care of, and it would be discussed when he raises the first investment.

I told him that while I watched him grow up and I was always impressed with him, I felt I needed to tell him some things about what he was doing that he apparently was not aware of. I also told him that asking people to invest carries with it a responsibility for some “due diligence” on his part, which it appears he did not do.

He never heard the expression due diligence and asked me what I think he should have done. My reply follows. It turned out to be a mini lesson on how the entire private investment process works.

For starters, a business plan needs to be that which would explain the type of business, competitors, potential customers, industry, why this company will be better, what they are offering to do that doesn’t already exist, and bios of the people who will run it. Also needed are financial projections for a five-year period. The projections need to show the projected operations and profitability, how much is needed, and how it would be utilized, along with the cash flow for the next five years and balance sheets for each period. Further, each item in the projection should be explained and how it was arrived at. It is very important to show the amount being raised is adequate to accomplish their goals. If debt or later-stage investments would be necessary, that should be clearly provided for in the projection.

Also shown should be the capital structure, what percentages the founders will have, any expected dilution because of new investors, what the founders’ investment contribution will be, and their compensation. If there are any stock options or any other arrangements for added compensation or benefits, that should also be disclosed.

Due diligence is the process of verifying the claims made by the people you will be dealing with. In this situation, it would be the founders. Also, my friend’s son was offered compensation, but it wasn’t clear how much, how it would be determined or whether it would be in cash, stock, options or a combination of these. Further, anyone setting out to engage in any business venture of any type should be clear about the responsibilities of each party and the compensation, and that there is the ability to pay the compensation. A general rule to follow is that services are much more valuable to the customer before they are rendered than afterward. Additionally, the seller is in a much stronger position before doing any work than after they’ve performed the services. Also, while many people start out with great and sincere intentions, they might forget some of what they agreed to, the minutiae of implementation might not be thought through, and people’s purposes might get sidetracked by newer opportunities. 

If the company is already operating, then financial statements should be provided.

Getting back to this investment “opportunity,” nothing was provided that would allow a potential investor to make a decision to invest.

My experience has shown me that many times there are likely targets for such opportunities, but there is only one shot at them. Not being fully prepared creates a wasted chance with that resource.

Most business plans will require a confidentiality or nondisclosure letter or agreement before they are provided. However it is important to assume that nothing will be kept confidential and proprietary, or sensitive information should not be disclosed until there is a serious investor.

I wrote a 20-page memo on how to prepare a business plan and financial projection that I will send you if you email GoodiesFromEd@hotmail.com and put “Business Plan” as the subject. No messages necessary.

Do not hesitate to contact me at emendlowitz@withum.com with your practice management questions or about engagements you might not be able to perform.