You don’t need to be a financial accountant to use proforma estimates to value an equity crowdfunding investment
One of the most neglected pieces of equity crowdfunding analysis is the proforma analysis of financial statements. Just the name alone puts most investors to sleep.
Building a proforma analysis is simply using management guidance and your own research on the industry to estimate sales and expenses a few years into the future. I usually stick to three years but have seen others try to project out five years.
Estimating company results, especially a startup’s numbers, involves a lot of research and is never going to be perfect but it can be one of your best tools in separating the certain failures from the deals that have a chance of returning 10-times your money and more.
Building proforma financial statements is common in analysis of publicly-traded stocks. Sales and expenses are more easily estimated and the future for large companies is less uncertain.
That uncertainty around…well everything in a startup company makes proforma statements even more difficult but no less important to estimating the investment outlook.
You don’t need to be an accountant to estimate a proforma income statement for a company. It takes some research and understanding of the industry. If that sounds like too much work to avoid losing thousands of dollars, maybe you should reconsider investing in equity crowdfunding deals at all.
Why Investors Need to Build Proforma Estimates
I’ve seen some angel investors completely neglect proforma analysis of startup companies. Granted, it is very difficult to estimate future sales and expenses and even the best estimates are going to be way off from actual numbers.
What proforma estimates help to do is to find a more rational perspective on a company and the investment.
Management is always overly-optimistic and almost all of the commentary you are going to see on the investment will be skewed. Other investors have an incentive to pull more people into the deal and few are going to say anything bad about the offer.
It’s almost as if the entire startup investing community was listening to your mother say, “If you don’t have anything nice to say, don’t say anything at all.”
With all this optimism around a company and its offer, it helps to step back and take an objective look at the numbers.
While you’ll still need to rely on management expectations to a point, you’ll build in your own estimates with information from your market research and other sources. Building a proforma not only helps to see what is likely in sales and earnings but also helps to develop what-if scenarios around high and low outcomes.
Read this earlier article on how to do market research for an equity crowdfunding investment
A proforma is just another check to make sure you don’t invest in a company that has no shot at being successful.
The average angel investment portfolio sees more than half its deals return less than the original investment, many of them flat out busting and returning nothing. Don’t you want to use every tool to avoid the bad investments?
How to build a proforma income statement
I generally build out proforma balance sheet and cash flow as well but a simple income statement is sufficient for most investments. Building out and linking the other two statements involves another level of understanding in financial accounting.
So how do you build a proforma income statement for your crowdfunding deal?
It all starts with sales. Management will usually give some pie-in-the-sky estimate for how much sales the company can reach over the next three to five years. My daily funny is when I ask management to support their reasoning for these expectations during the deal interview.
Any entrepreneur that tells you they are going to jump into a competitive market and get more than 5% of total sales within a few years needs to be institutionalized. There will be better opportunities in undeveloped markets and those with fragmented competition but a company usually isn’t going to just steal market share overnight.
That’s why most angel investors and VC firms want to see a market of at least a $200 million or more. Grab even a couple percent of that and you’ve got $4 million in annual sales pretty quickly.
As with most of the proforma estimates, look back through the history of the publicly-traded companies in the market. They will issue 10-k statements annually with financial statements and detail on the business. If you’re lucky, there will be a few that are fairly new businesses and you can get an idea of what their business was like in the early days. Remember though that these companies probably operated for years as private or startup companies before going public and issuing the reports.
There are quite a few ways you can estimate sales. I usually use management estimates along with early-stage growth at competitors. It’s also useful to develop three scenarios where management estimates are best case and you estimate a base- and worst-case scenario.
The point of a proforma financial statement is to see what is realistically possible with sales and earnings. On each line item you estimate, come back to that concept.
- Can the company produce that level of sales with current or planned production facilities? As sales grow, the company will likely have to spend money on production which will increase expenses.
- Will competitors start to compete with promotions if the company starts to take significant market share? How will that competition affect sales?
Cost of goods sold (COGS) is the cost of supplies and raw materials to produce the company’s product. COGS won’t be very high at a service-related company but will be a significant item for a company with a physical product.
Publicly-traded companies will be a good source for estimating cost of goods. It is usually a fairly stable percentage of sales. Other companies’ financial reports will also talk about trends in materials costs. An early-stage company may have to pay higher COGS if it cannot get bulk discounts or doesn’t have preferential contracts with suppliers.
The bulk of a proforma income statement is estimating operating expenses for the company. There are quite a few items that can be included but the most important will be staffing (general & administrative), research & development and marketing expenses. These three items tend to be the bulk of a start-up company’s costs and critical to business development.
Some items can be estimated as a percentage of sales each year. It stands to reason that the amount of marketing a company does is directly related to the amount of revenue it can produce. Be extremely wary of an entrepreneur that forecasts huge sales growth but little growth in marketing expense. They are either hiding the truth or know nothing about corporate finance.
Line items that are often a percentage of sales:
- Equipment & Maintenance
You’ll still have to do some research and guesswork for these and other expense items. Administrative expenses may trend along with sales but staffing costs will be more volatile, jumping when new staff is needed before increases smooth a little. Research & development costs will lead sales by years so you may want to estimate R&D as a percentage of forecast sales in the following year or two.
Publicly-traded companies are again your best source for insight in the percentages you use. Understand that a new company is going to have higher expenses for R&D, marketing and staffing relative to sales. A startup doesn’t have the momentum that larger companies have so needs to jumpstart sales by spending more on product development and advertising.
Notice that I usually include two columns in my proforma statement that compare the percentage of sales for each line item in the current year with that of the last year estimated. Some lines like COGS may maintain the same percentage while others might change over the period. A company will start to see most of its operating expenses come down relative to sales as it matures and becomes more efficient.
Estimating depreciation of property, plant and equipment is more difficult and necessitates keeping a schedule of assets. You can get away with not including the item for most companies, especially those without a lot of production equipment.
One item that frequently gets missed is stock-based compensation. Most early-stage companies pay out a lot of employee pay in the form of annual stock or options. Unless management explicitly says it will stop the practice then I usually estimate an annual charge or add it to the shares outstanding.
EBT in the graphic is earnings before taxes. You may also see this as earnings before interest and taxes (EBIT) though many startups will not have debt on which to pay interest.
A few questions to ask when estimating operating expenses:
- What percentage is each item relative to sales for public companies?
- Are the percentage of sales for each item at comparable companies fairly static or does the expense change?
- What is the operating margin (operating gain divided by sales) at comparable companies? Few startups are going to be as profitable as older competitors.
- Is management guidance for the important items like staffing, R&D and marketing even close to your estimates?
Net operating losses (NOL) is something that even some analysts miss but is extremely important when building out your proforma estimates. The government says that a company can offset future taxes by losses booked in the past, it’s a powerful tool for early-stage companies that must endure years of losses.
Companies can carry losses forward for a maximum of 20 years, well beyond where we will be estimating the income statement. Most early-stage companies are barely going to be profitable within a three- to five-year time period so accounting for a NOL is straight forward. You simply add together all the losses in prior years to offset profits during your proforma years.
When profits start adding up to more than prior losses, then you start reducing earnings by income taxes at the corporate rate.
I also estimate average shares outstanding with my proforma analysis, something that requires a cash flow statement and balance sheet. Almost all startups need funding beyond the initial rounds of startup capital. For most companies, you are more concerned about the level of sales, expenses and if the company can simply generate a profit. The actual share count and earnings per share over the period are not as important.
Want to know more about what to expect with equity crowdfunding? Check out this post on the funding cycle of startups and equity crowdfunding investments.
How to Use Proforma Income Estimates
Your proforma income estimates are never going to be what the company actually produces in the future. Even the best estimates are generally well off actual numbers but constructing a proforma statement is still very useful for two reasons.
- As a check on management guidance and a reality check on the investment
- As a valuation tool on the deal
We’ll talk about using the proforma estimates as a valuation tool in a later post when we talk about discounted cash flow (DCF) analysis. Using DCF involves using the estimated cash flows from the business to arrive at an enterprise value over your investment time frame. It’s one of the three valuation tools, along with comparable multiples and M&A analysis, to arrive at a blended estimate of value.
The more important use of a proforma analysis is simply as a reality check and to put everything in numerical perspective. Against the lofty expectations of management and the optimism from other investors, it can be easy to get swept up and forget that investing in startups is all about the potential for profits.
By researching what competitors are able to do in the market and preparing different scenarios for sales and expenses, you can start to get a better idea of the startup’s viability. Your proforma estimates don’t need to be perfect. Just comparing a few realistic estimates with management’s guidance can help to avoid a few borderline deals.
That alone will put you way ahead of most investors and can significantly increase your overall portfolio return. If about 55% of angel investments return less than the original investment or nothing yet the group still averages about 25% annualized return, imagine what your return will be like if you reduce the failed investments down to even 45% of your total deals.
Just reading through the process of building proforma estimates for equity crowdfunding investments, you can get a sense of why many analysts and angel groups focus on specific sectors or industries. It helps to have detailed knowledge within a sector to estimate financials and to cut down on your research time for each investment offer.
You can invest across many sectors though and you’ll build your library of research fairly quickly to make future deal analysis easier. Don’t worry about making your proforma estimates for equity crowdfunding investments perfect but don’t neglect doing them either. The payoff will be fewer failed investments and a portfolio that jumps higher.