The Purpose of Financial Projections
When it comes to financial projections, there are two types of entrepreneurs: first, the "visionary entrepreneur" who considers financial projections silly, so she makes up numbers that look good to investors; second, the "intense entrepreneur" who develops an 10,000 cell spreadsheet that includes the number of licenses of Microsoft Office that he needs to buy in year five.
If you are the first type of entrepreneur, you run the risk that the investor won't trust you with his or her money. This type of entrepreneur often alienates investors because of his cavalier attitude. If you are the second type of entrepreneur, you run the risk that the investor will think that you actually believe your projections.
When it comes to financial projections, however, there is only one type of investor: people who don't believe your financial projections, whatever they are.
So what's the right balance of vision versus detail? The point of financial projections is to tell a story with numbers-a story about opportunity, resource requirements, market forces, growth, milestone achievements, and profits. Your job is to create a numerical framework that complements and reinforces the vision you've painted with words.
The investor isn't interested in the precision of the numbers, but he or she is interested in what the numbers say about the economics of your business, and what they say about your understanding of your business. The goal is to tell a credible, as well as exciting, story about what your business could become.
To be credible, your numbers have to make sense on the first review. If you are suggesting that your company will grow faster or be more profitable than any company in history, you will lose credibility. Your numbers must survive simple questioning:
The reason to develop a financial model of your business for five years going forward is to make explicit the driving factors behind your revenues and expenses as you pass through several stages of product development, market penetration, and organization growth. As they say, if you don't know where you're going, any road will get you there.
Most important, you need to show investors how you will grow your company from the bottom up-sale by sale, employee by employee-rather than building a model from the top down. No one believes that a model built on getting "only one percent of the target market" is a credible plan.
You won't be presenting your operating plan to investors in your first few meetings, but you'd better understand how you are going to run the business once you raise capital. A well thought-out operating plan will reflect your ability to allocate resources-people and money-to the highest priority objectives.
Building from the Bottom Up
The problem with financial accounting, however, is that it forces you to present your numbers using big company functional categories, such as sales, marketing, engineering, general, and administrative. But startup companies really operate as projects, with most projects running across functions.
You need to run your company as a startup, but present your financials using the standard framework of accounting. That means that the details of your operating plan will reside in a model built around the activities required to achieve your critical milestones.
That way, when an investor drills into why you are planning to spend money the way you are, you can frame your answer in terms of business priorities and deliverable milestones, rather than saying something like, "Most companies spend 25% on sales."
Still, building your operating plan from the bottom up based on projects you need to execute is challenging. We all over-estimate how much we can accomplish in a month. Make sure your projections are tempered by real world experience. You want to over-deliver during those early years, not under-deliver. You don't want to have to ask for more money before you've proven what you promised to prove.
Two Final Tips
First, don't call your projections "conservative." We refer to this as Entrepreneur Lie #1. Investors want to see a bold plan that is well thought-out and realistic, if everything goes reasonably well. They don't want to see a delusional plan. Your job is to show that you have tapped a team with the experience and insight to justify your bold optimism.
Second, model your company on other real world successes. You don't have to make up your business model. You should be able to model your financial projections on companies that have been successful before. Use the S-1 IPO filings of companies with business models similar to yours to get an idea of what is realistic. If your projections are wildly different than other highly successful companies, then your assumptions are probably off.
Conclusion
Your operating plan and your longer-term projections will evolve. You should be constantly engaged in testing your assumptions and adjusting your actions as you learn. The trick is making sure you are always using your precious resources-people and money-most effectively, for the highest return, rather than letting inertia perpetuate activities and expenditures that are not productive.
It's obvious, but it's true: The number one cause of failure is running out of money. And the number one cause of running out of money is the failure to grow revenues faster than you are growing expenses.
As much as your investors may tell you, "We back teams," they expect you to make money. If you deliver on your numbers, you will become rich and successful. If you fall short, you won't. So as much fun as it is to paint an exciting vision, at the end of each month, you will be measured on your ability to deliver what you promised.
Good luck!
When it comes to financial projections, there are two types of entrepreneurs: first, the "visionary entrepreneur" who considers financial projections silly, so she makes up numbers that look good to investors; second, the "intense entrepreneur" who develops an 10,000 cell spreadsheet that includes the number of licenses of Microsoft Office that he needs to buy in year five.
If you are the first type of entrepreneur, you run the risk that the investor won't trust you with his or her money. This type of entrepreneur often alienates investors because of his cavalier attitude. If you are the second type of entrepreneur, you run the risk that the investor will think that you actually believe your projections.
When it comes to financial projections, however, there is only one type of investor: people who don't believe your financial projections, whatever they are.
So what's the right balance of vision versus detail? The point of financial projections is to tell a story with numbers-a story about opportunity, resource requirements, market forces, growth, milestone achievements, and profits. Your job is to create a numerical framework that complements and reinforces the vision you've painted with words.
The investor isn't interested in the precision of the numbers, but he or she is interested in what the numbers say about the economics of your business, and what they say about your understanding of your business. The goal is to tell a credible, as well as exciting, story about what your business could become.
To be credible, your numbers have to make sense on the first review. If you are suggesting that your company will grow faster or be more profitable than any company in history, you will lose credibility. Your numbers must survive simple questioning:
- Do the capital requirements shown in your projections match the funding you are asking for?
- Do you know how many customers you have to land to generate the revenues you are projecting?
- Do you know how long it takes and how much it costs to acquire a customer?
- Do you know what resources will be required to support customers?
- Do you know how much you will have to spend to stay ahead of the competition with your product or service offering?
The reason to develop a financial model of your business for five years going forward is to make explicit the driving factors behind your revenues and expenses as you pass through several stages of product development, market penetration, and organization growth. As they say, if you don't know where you're going, any road will get you there.
Most important, you need to show investors how you will grow your company from the bottom up-sale by sale, employee by employee-rather than building a model from the top down. No one believes that a model built on getting "only one percent of the target market" is a credible plan.
You won't be presenting your operating plan to investors in your first few meetings, but you'd better understand how you are going to run the business once you raise capital. A well thought-out operating plan will reflect your ability to allocate resources-people and money-to the highest priority objectives.
Building from the Bottom Up
The problem with financial accounting, however, is that it forces you to present your numbers using big company functional categories, such as sales, marketing, engineering, general, and administrative. But startup companies really operate as projects, with most projects running across functions.
You need to run your company as a startup, but present your financials using the standard framework of accounting. That means that the details of your operating plan will reside in a model built around the activities required to achieve your critical milestones.
That way, when an investor drills into why you are planning to spend money the way you are, you can frame your answer in terms of business priorities and deliverable milestones, rather than saying something like, "Most companies spend 25% on sales."
Still, building your operating plan from the bottom up based on projects you need to execute is challenging. We all over-estimate how much we can accomplish in a month. Make sure your projections are tempered by real world experience. You want to over-deliver during those early years, not under-deliver. You don't want to have to ask for more money before you've proven what you promised to prove.
Two Final Tips
First, don't call your projections "conservative." We refer to this as Entrepreneur Lie #1. Investors want to see a bold plan that is well thought-out and realistic, if everything goes reasonably well. They don't want to see a delusional plan. Your job is to show that you have tapped a team with the experience and insight to justify your bold optimism.
Second, model your company on other real world successes. You don't have to make up your business model. You should be able to model your financial projections on companies that have been successful before. Use the S-1 IPO filings of companies with business models similar to yours to get an idea of what is realistic. If your projections are wildly different than other highly successful companies, then your assumptions are probably off.
Conclusion
Your operating plan and your longer-term projections will evolve. You should be constantly engaged in testing your assumptions and adjusting your actions as you learn. The trick is making sure you are always using your precious resources-people and money-most effectively, for the highest return, rather than letting inertia perpetuate activities and expenditures that are not productive.
It's obvious, but it's true: The number one cause of failure is running out of money. And the number one cause of running out of money is the failure to grow revenues faster than you are growing expenses.
As much as your investors may tell you, "We back teams," they expect you to make money. If you deliver on your numbers, you will become rich and successful. If you fall short, you won't. So as much fun as it is to paint an exciting vision, at the end of each month, you will be measured on your ability to deliver what you promised.
Good luck!
