Due Diligence: Assessing Your Organization (2)

In the last edition, we explored the foundational aspects of due diligence that every impact-oriented organization should be aware of. This week, we’ll zoom in on financial due diligence, one of the most critical components of the process. In this edition, Devashish Taknet, Director of Philanthropy at Upaya Social Ventures writes about this important part of due diligence. This edition is quite content-heavy, so, take some time this weekend to read through carefully.

For many impact investors, financials reveal how well an organization can manage its resources, scale, and deliver impact sustainably. Here’s what social entrepreneurs need to understand to be investment-ready from a financial perspective.

What is Financial Due Diligence?

Financial due diligence is an investor’s way of understanding your organization’s financial health, revenue streams, cost structure, and sustainability. In simple terms, it helps answer the question: Can this organization deliver impact while being financially sound? For impact investors, it’s not just about turning a profit; it’s about ensuring that an enterprise has a stable financial foundation to continue its mission of creating social good.

The goal of financial due diligence is to ensure transparency, identify risks, and verify the financial information presented by the organization. Investors will assess various documents such as your income statements, balance sheets, cash flow statements, and financial forecasts.

Understanding Your Key Business Drivers

Before delving into financial metrics, it's crucial to understand and articulate your business drivers—key inputs and activities that drive the operational and financial outcomes of your organization. There are six primary business drivers:

1. Size: Measured by the total sales of goods and services, indicating the overall scale of the business.
2. Growth in size: The year-on-year increase in sales, that reflects business expansion.
3. Operating margin after tax: The ratio of net operating profit after tax (NOPAT) to sales, showing profitability after taxes.
4. Net operating asset intensity: The ratio of net operating assets (NOA) to sales, indicating the efficiency of asset utilization to generate revenue.
5. Business risk: The variability of returns due to factors inherent to the operations of the business.
6. Financial risk: The degree of leverage or debt relative to equity, reflecting the risk of financial obligations.

Together, these drivers provide investors with a comprehensive view of your organization's operational efficiency, growth potential, and risk profile. By clearly defining and managing these drivers, you can provide a compelling case to investors.

Key Financial Metrics to Get Right

Impact investors look for certain financial metrics to ensure that your organization is well-positioned to grow and create lasting impact. Here are the key areas that must be in order:

1. Revenue Streams

Do you have a clear understanding of where your revenue comes from? Whether your organization depends on product sales, service fees, grants, or donations, it’s important to show diversified revenue streams or at least future plans for it. A diversified income base mitigates risk, as an organization is less dependent on a single source of funding.

2. Cash Flow Management

Cash flow is the lifeblood of any organization. Investors want to see if you can manage your cash effectively. Do you have enough reserves to cover operating costs and withstand periods of low revenue? Transparent and steady cash flow signals that your organization can continue to operate without disruption, which is vital for both your mission and investors’ confidence.

3. Profitability and Unit Economics

While some social enterprises may be in early stages and not yet profitable, understanding your unit economics—how much it costs to acquire and serve each customer or produce each unit—is essential. Investors will evaluate whether your cost structures make sense and if you have a clear path to profitability over time.

4. Debt and Liabilities

It’s important to demonstrate your ability to manage debt. Impact investors will assess your organization’s liabilities to understand how they may affect long-term sustainability. Too much debt or unmanageable liabilities can pose a risk, so transparency here is crucial.

5. Financial Projections

What does the future look like for your organization? Financial projections allow impact investors to understand your growth trajectory. Make sure your forecasts are realistic and based on tangible data, such as historical performance or market research. Investors are looking for projections that indicate both financial and impact growth.

Balancing Impact and Growth

Balancing impact with business growth is key to scaling and attracting funding, as Ankur Mehta, Director of Investment & Portfolio at Upaya Social Ventures, emphasizes:

“Social enterprises face the unique challenge of balancing impact with business objectives, as their ability to scale impact is often tied directly to business growth. Growth-oriented enterprises are more likely to attract funding, making it crucial for them to have a clear, well-defined roadmap. They must not only articulate their growth strategy effectively but also understand the key inputs required to achieve their desired outcomes.

For example, consider an enterprise producing organic fertilizers for farmers. Their 3-year plan may look like: Sell X tons of fertilizer to Y farmers, generating Z revenue. Achieving this goal requires several key inputs, including: (a) R&D capabilities, (b) hiring team members across various functions, and (c) securing funds for setting up a manufacturing facility and covering working capital needs. A well-crafted business plan should clearly outline when and how these inputs will be utilized to achieve the goal. Such a roadmap not only provides clarity to the founders on the steps and challenges in scaling the business but also instills confidence in potential investors.”

Preparing for Financial Due Diligence: Practical Steps

Here are a few practical steps you can take to ensure that your financials are ready for due diligence:

1. Keep Records Up-to-Date It’s essential to maintain up-to-date financial statements. This includes income statements, balance sheets, and cash flow reports. Inaccurate or outdated financial records can raise red flags for investors.
2. Understand Your Financial Story Be prepared to explain the financial history and trajectory of your organization. Investors want to hear the story behind the numbers—how revenue is growing, what challenges you’ve faced, and how you’re working towards sustainability.
3. Highlight Cost Management Efforts Impact investors want to see how well you’re managing costs, especially in challenging environments. Highlight areas where you’ve made efficiency improvements or found innovative ways to lower operating expenses without sacrificing impact.
4. Audit and Transparency If possible, consider conducting an internal or external financial audit before approaching investors. This shows transparency and accountability—key traits that impact investors value highly.

Common Financial Red Flags to Avoid

There are certain issues that can raise concerns for impact investors during financial due diligence:

• Unrealistic Financial Projections: Overly optimistic projections can signal poor planning. Ground your projections in reality.
• Inconsistent Record-Keeping: Gaps or discrepancies in financial data can erode trust.
• High Dependency on a Single Donor or Funder: This poses a risk to your organization’s long-term sustainability.

Getting your financials in order is not just about impressing impact investors—it’s about ensuring your organization is built for the long haul. It’s a tool for growth, resilience, and ultimately, for delivering meaningful, lasting impact. In the next edition, we will continue with impact due diligence.

Worth Reading

Sequoia's guide to pitching an early-stage enterprise 

Accounting and legal terms that founders should know/measure in their businesses 

1. Burn Rate: The rate at which an early-stage enterprise is spending its capital, typically on operating expenses, before it becomes profitable.

2. Runway: The estimated amount of time an early-stage enterprise can operate before running out of funds based on its current burn rate and available capital.

3. CAC (Customer Acquisition Cost): The cost an early-stage enterprise incurs to acquire a new customer, including marketing and sales expenses.

4. CLTV (Customer Lifetime Value): The estimated total revenue an early-stage enterprise expects to generate from a customer throughout their relationship with the company.

5. Churn Rate: The percentage of customers who stop using a product or service within a specified period, often measured monthly or annually.

6. LTV/CAC Ratio: The ratio of Customer Lifetime Value to Customer Acquisition Cost, used to assess the efficiency and sustainability of customer acquisition efforts.

7. MRR (Monthly Recurring Revenue): The total revenue generated from subscription-based products or services on a monthly basis.

8. ARR (Annual Recurring Revenue): The total revenue generated from subscription-based products or services on an annual basis.

9. CAC Payback Period: The time it takes for an early-stage enterprise to recoup the cost of acquiring a customer through the customer's subscription or purchases.

10. Gross Margin: The percentage of revenue remaining after subtracting the cost of goods sold (COGS), indicating an early-stage enterprise's profitability.

11. Run Rate: An extrapolation of an early-stage enterprise's current financial performance to estimate its annual performance.

12. GMV (Gross Merchandise Value): The total value of goods or services sold on a platform or marketplace, excluding fees and discounts.

13. Liquidity Event: An event, such as an acquisition or IPO, that provides investors with the opportunity to realize a return on their investment.

14. Dilution: The reduction in the ownership percentage of existing investors or founders when new equity is issued, such as in subsequent funding rounds.

15. Liquidation Preference: A clause in a VC investment agreement that specifies the order in which investors receive proceeds in the event of a liquidation or exit.

Highlighted Resource

Templates for founders: financial model, pitch deck, KPI, one-pagers, etc.

Top 15 accelerators for early-stage enterprises

1. A16Z GAMES SPEEDRUN | Pre-Seed, $750k 

2. Entrepreneur First | No idea, No team, $250k for ~9%

3. South Park Commons | Pre-Idea, $1M

4. Antler Global | Pre-Seed, $250k for 9%

5. Sequoia Capital Arc | Pre-Seed, Seed $500k - $1m

6. HFO Residency | Pre-Seed, $500k uncapped + 3%

7. Pear VC | Pre-Seed, $250K - $2M

8. Techstars | Pre-Seed, $100k for 6%

9. 500 Startups | Pre-Seed, 112.5k for 6% 

11. Boost VC | Pre-Seed, $50k - $500k 

12. Berkeley SkyDeck | Pre-Seed, $200k for 7.5%

13. Pioneer | Pre-Idea, $20k for 1% 

14. Seedcamp | Pre-Seed, Up to £1M 

15. AngelPad | Seed, $120k for 7%

End Notes

If you have a product or resource that can be helpful to an impact-oriented organization on its way to becoming investible, fill out this Google form. Who knows, you might be featured in the highlighted resource section.

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PS: Are there topics you would like to see covered? Share them, and I will see how to add them to the existing content schedule.