February 24, 2015, 9:06 AM ET

By Jonathan Lehr

The “why” of working with enterprise startups is pretty clear and has been written about ad nauseam over the last few years. What’s less clear are many details on how to evaluate startups’ financial risk. If you only take away one thought from this entire post, be sure to remember that the key is holistically evaluating the company’s financial viability.

My hope is that this post can educate corporations to effectively evaluate the financial viability of startups and avoid gut reactions that startups are “too small” to consider. From the startup perspective I hope that this transparency into their evaluation process will empower them, reduce associated stress and anxiety of such reviews, and let them focus on what’s important: continuing to grow their companies!

Some background. Before leading Work-Bench Ventures and making investments in early stage enterprise startups, I was a member of Morgan Stanley ’s Technology Business Development team in IT. It was an Office of the CIO type role and had two functions – identifying startups which could potentially solve pain points across IT, and performing financial due diligence of all of the firm’s technology suppliers. The latter responsibility serves as the inspiration for this post, and for this overview I’ll focus just on enterprise startup analyses (and ignore public company analyses).

Because of FFIEC regulations, each and every private company that wants to do business with the firm has to submit financial statements for review. After financials get reviewed, a meeting with a C-level executive (usually CEO or CFO) from the company is scheduled to walk through the story and get more insights into the company’s future plans.

Based on the meeting and the financials, we’d evaluate the company across four areas.

Management team. When looking at the management team, domain expertise is always a nice plus.  Serial entrepreneurs also bring credibility to help de-risk growth and execution challenges. Things to look for include:

The earlier the company, the more important it is that there are enough folks in R&D and support. This offers assurances that new features will continue to be built off the product roadmap, and that any issues will be fixed in a timely manner.

Liquidity and capitalization planning. Cash relative to burn is a key data point to know in order to get a sense of whether there is any imminent threat of the company going under. When a company is operating at a loss, having nine to twelve months-worth of cash on hand relative to net burn is a sufficient cushion if tied to realistic future funding plans. Among the items to study are:

Regarding the VCs, the quality of the investors matters because their reputation can be a positive for the company (i.e. if the VC has a successful track record and this company passed their diligence process), and committed institutional investors are more likely to support companies in rough times versus abandoning them like many non-institutional investors may do.

Company stage. It is important to understand the difference between GAAP revenue and bookings, especially as it relates to SaaS companies given VSOE rules.  GAAP Revenue will significantly trail bookings and not give an accurate portrayal of a company’s growth and momentum.  This is a commonly misunderstood point, and why you can’t just rely on financial statements for your review since they don’t tell the full story. Questions to ask include the following:

For SaaS companies, recurring revenue should be 85-90% with the remaining 10-15% related to professional services for implementations. If recurring revenue isn’t high, how much of the company’s sales are one-off, custom engagements that aren’t scalable?  Lower recurring revenue each year also means that they’ll have less visibility into things like budgeting future year expenses since they don’t have a solid revenue base to plan against.

Renewal rates should also be high, and ideally be 95%+ for growing companies.  Some may even be over 100% when their churn is minimal and they upsell existing customers.

The percentage of revenue from the company’s top 10 customers helps identify if there is any revenue concentration risk.  Ideally the top 10 customers should be <40% of a company’s revenue, but for earlier stage companies just getting going, this will of course be unavoidable.

Market. Looking at the market size and competitive landscape gives a sense of how big this company can get and if they can build a sustainable business.

A big question comes down to the founders being able to clearly articulate their vision for the company, and what their secret sauce is to make it a success relative to incumbent providers and any other competitors.

Scoring. Remember I said the word holistic before. Well it comes into play here. Even if a company is small from a bookings perspective or is not yet profitable (which frankly most growing venture backed companies intentionally won’t be), as long as they have a strong management team and sufficient liquidity, then a company isn’t dead on arrival and can potentially be safe to work with.

All four areas get individually scored and then a weighted average score (I can’t disclose the relative weight of each of the four sections) is calculated.  Based on the score, there are different risk tiers (low risk, moderate risk, high risk, and critical risk), which factor into what type of opportunities internally the company can be a fit to support. After the assessment, the risk tier and high level information about the company is shared with the stakeholders who requested the evaluation.

Confidentiality of the company’s sensitive information is maintained, but enough high level information can be shared that it aids in the decision of how to proceed.

Depending on the risk level of the company, these reviews need to be refreshed every 6 months to 3 years to get an update on the company’s progress.  Most startups tend to fall in the 6 month to 1 year category for updated reviews.

Questions? Comments? Please share your thoughts in the comments or on twitter (I’m @fendien) and I’ll gladly answer any follow-ups.

Jonathan Lehr is Venture Director at Work-Bench where he focuses on early stage enterprise technology investments.  He previously worked at Morgan Stanley in IT and is the Founder of the NY Enterprise Technology Meetup.