By Maureen D. Barry, CPA and Dustin M. Wehman, CPA, CFE
As an entrepreneur, the excitement you feel about your company can be overwhelming.
You know that with only a “little bit of money” you can launch your company or take your company to the next level. The big meeting with a potential investor started off great, but then the investor asked you “operational” questions. A few pleasantries later and you are out the door. This is an entrepreneur’s worst nightmare, and maybe the quick exit could have been avoided.
While investors understand the passion of the entrepreneur, first and foremost they are looking to invest in a business, not simply your passion. The first item that you will want to be certain is set up correctly is the legal entity structure, and you will want an entity that provides liability protection in most instances – such as limited-liability LPs (“LLLPs”), limited partnerships (“LPs”), limited liability companies (“LLCs”) and corporations. The second concern when selecting an entity would relate to the flexibility of who are the owners – now and in the future.
With some entity structures, you will need to elect an entity for tax purposes. For example, a LLC does not specify a specific tax election. The determination of which type of tax entity would suit your company best will be based on the number and type of shareholders/partners/members – now and in the future. A venture capital group, in many cases, will want to invest in straight subchapter C corporations. Entity structure and tax entity choices will also determine how you are compensated as an owner-employee or a partner, assuming there are funds for a salary, draws or guaranteed payments.
While investors understand the passion of the entrepreneur, first and foremost they are looking to invest in a business, not simply your passion.
Complications arise for partners when they are surprised to learn that the income they have accepted via guaranteed payments is likely subject to income taxes, and these individuals may be unaware of the personal tax estimates that may need to be paid throughout the year on those payments. Additionally, certain entities limit the types of equity awards that may be issued as non-cash compensation for employees.
Another key component of a business is establishing an accounting system. The shoeboxes and spreadsheets must be replaced with an actual filing system and basic dual-entry accounting software. There are many products available, which provide basic accounting functionality at a low price point. When an investor asks to see your numbers, the expectation is that you can readily produce a balance sheet, trailing 12-month income statement and up-to-date capitalization table. Investors will also be eager to review your cash flow and understand your current burn rate. This information is not just important for investors; you cannot run your business effectively without good data. If your records are a mess, potential investors will move on to the next deal and you will be paying more at year-end for your accountant to prepare a tax return.
Investors see similar revenue projections for almost every company they meet – the beautiful hockey stick that illustrates tremendous growth over the next five years. If you project such growth, you will need to be able to concisely articulate how you intend to achieve your intended growth. This statement does not mean you should adopt an attitude toward “under-promise and over-deliver.” Your projections should be reasonable, optimistic and as aggressive and energetic as you are. The key is drawing the correlation between your expenditures (including the funds you seek to raise) and the projected returns. You need to demonstrate that you are running a business and that you understand how each dollar that is invested will lead to the growth of your company. Give your dream a head-start; the road ahead for every entrepreneur is filled with obstacles, and establishing the right structure for your business will help you clear the hurdles that lie ahead.