Most aspiring entrepreneurs understand that you can’t build a business if you won’t commit to delivering a product or service, but many are hesitant or refuse to commit to any financial forecasts. Yet every business requires revenue and volumes, as certainly as it requires a product to sell. Thus, financial projections for up to five years are a necessary element in every business plan.
External investors will demand a financial forecast, but it’s equally valuable to you, even if bootstrapping. How else will you be able to convince yourself and your team that your business is viable? You need these projections to set internal goals and milestones, and to measure your progress toward reasonable success objectives.
For investors, and even for yourself, it’s also a bit of an intelligence test. Per the words of an old country song, “if you don’t know where you’re going, you will probably end up somewhere else.” If you don’t have a destination, don’t waste your money trying to get there, and don’t expect anyone to support you along the way.
Projecting financials is a natural extension of the homework every entrepreneur needs to do on customer opportunity size, product costs, pricing, competition and customer value. There is no black magic involved in predicting the future, if you use these four simple steps, with my basic rules of thumb to keep you on the right track:
- Determine your margin on sales. Per-unit cost less cost of goods sold is your gross profit or margin. If you are losing money on every unit, it’s hard to make it up in volume. As a rule of thumb, most viable businesses need a gross margin above 50 percent, even on wholesale prices, to cover operational expenses and survive as a business.
- Forecast sales-volume expectations. Project based on your market size how many widgets you will sell in every channel. This should always be a “bottoms-up” commitment from your sales team, not your own optimistic guess. Don’t assume penetration numbers greater than 5 percent in early periods. Doubling revenue each year is a good target.
- Quantify overhead costs. It’s amazing how fasts costs escalate as you grow. You need 5 percent or more of revenue for marketing, maybe more for ongoing development, and people costs will double as you add benefits, insurance, training, IT and new processes. Check competitor numbers and industry average statistics to get you in the right range.
- Calculate investment amounts and timing. Initial sales success means more cash will be needed for inventory, receivables, facilities and people. Project your cash burn rate to keep at least 18 months between venture capital or angel investments. Controlling cash flow is critical as founders move from working “in” the business to working “on” the business.
From a planning and strategy standpoint, I offer these additional recommendations to maintain your credibility with outside investors, and to balance your risk due to market uncertainty:
- Always buffer your investment requests. Investment requirements should always be based on financial projections and cash-flow calculations, not on what you think you can negotiate. If your cash flow shows a shortfall of $750,000, add a 33 percent buffer, and ask for a million. Be willing to give up 20 to 33 percent of your equity to support this.
- Update your financial projections every quarter. Financial forecasts for startups are assumed to be estimates that will be updated as real data comes in. Plan to re-forecast revenues quarterly or even monthly, and replace forecasts with actuals as soon as a period ends. A business plan with old projections instead of actuals has no credibility.
- Avoid conservative projections, as well as irrational ones. Investors want entrepreneurs to be aggressive, but don’t make projections that make you look like the next Google. Entrepreneurs tend to be driven by their own targets, so pick an aggressive one, and you will likely do better that starting with a conservative one.
I always recommend that entrepreneurs do their own financial projections, rather than rely on an outsider, because it’s the process that adds the value, more than the numbers. For additional value, I suggest the use of a spreadsheet such as Excel as a financial model, with a few variables, like price and volume. This allows a quick analysis of price change and revenue impacts.
